Many people are familiar with the stock markets. These centralized trading exchanges include the New York Stock Exchange, NASDAQ, London Stock Exchange, and the Johannesburg Stock Exchange, among others. They are centralized because trading and investing activity takes place at a fixed location.
OTC (Over the Counter) trading takes place through decentralized dealer networks. These market structures are comprised of a variety of technical devices, without a central location. Traders can buy and sell financial instruments such as currencies, commodities, indices, and stocks OTC. This is done through a dealer, electronically, or via telephone.
A combination of brokers and dealers make up the OTC market. A broker executes trades on behalf of clientele. A dealer executes trades on behalf of itself. Where financial instruments are concerned, dealers make decisions vis-a-vis the purchasers. Brokers only make purchases according to their client’s wishes. These are the fundamental differences between brokers and dealers.
What Makes up the OTC Market?
The OTC market typically includes much smaller financial instruments, such as penny stocks. Many of these stocks fall short of the market cap requirements needed to be listed on the central exchanges. OTC markets are also the de facto home for stocks that cannot maintain the threshold price level for listing on the centralized exchanges. There are other reasons why OTC trading of equities may take place, such as bankruptcy and liquidation filings.
It may come as a surprise to some, but several leading companies have chosen to remain on OTC markets, such as OTCQX. These include the likes of the Danone, Roche, Allianz, and BASF. For the most part, the OTC market comprises an interrelated network of companies which act in the capacity of market-makers for low-cost, low-trade volume equities such as penny stocks.
Recall that the NASDAQ definition of a penny stock is, ‘… A stock that typically sells for less than $1 a share, although it may rise to as much as $10 per share after the IPO, usually because of heavy promotion. All are traded OTC, many of them in the local markets of Denver, Vancouver, or Salt Lake City.’ There are key difference between stocks traded on a centralized exchange – listed stocks, and stocks traded OTC – unlisted stocks. These pertain to management boards, filing, earnings reports, reporting, stock price, and regulatory requirement differences.
Traders can access many different types of stocks OTC, including respectable stocks and less-than-respectable stocks. It’s incumbent upon traders and investors to do their homework before dabbling in OTC stocks. The fundamental difference between being listed and being unlisted pertains to regulation. Listed stocks are heavily regulated. Unlisted stocks aren’t. Many people still perceive over-the-counter stocks in a similar way to trading physical pink sheets of paper, this process is largely conducted online through broker/dealer exchanges.
The OTC Marketplace
The primary marketplaces for over-the-counter companies include OTCQX®, OTCQB®, OTCPK®, and grey sheets. These markets open at the same time as the regular exchanges – 9:30 AM until 4 PM, Monday through Friday. They don’t trade on public holidays.
- OTCQX, is preferred for well-established companies. It is ideally suited to US and international SMEs. Qualification for the OTCQX market necessitates compliance with corporate governance statutes, and high financial standards. This invariably entails full compliance with US securities laws, up-to-date disclosures, and professional third-party sponsor introductions. It should be noted that companies under bankruptcy proceedings, shell companies, and penny stocks do not qualify for OTCQX listing.
- OTCQB® markets are for venture market entrepreneurs. This is ideally suited to development-stage companies, notably US and international corporations. Eligibility requires up-to-date reporting, annual verification, no bankruptcy proceedings. These companies must also meet the $0.01 bid test.
- Pink sheets are traded on the OTCPK. These are unknown quantities, since they include bankrupt stocks, shell companies, and companies that are delinquent on their filings. There is little to no oversight with the OTCPK markets, and it is incumbent upon traders and investors to carefully assess stocks listed OTCPK.
- When OTC stocks are moribund, with companies under investigation, and many having caveat emptor designation, they become known as Grey Sheets. These stocks are best left alone for obvious reasons.
What Should You Look out for When Trading OTC Stocks?
OTC markets are ideal for companies that don’t want to list on exchanges and be subject to all the licensing, reporting, structural, and regulatory constraints. It’s much easier to simply trade OTC than it is on a centralized exchange. From a company’s perspective, the fees for listing can be upwards of $150,000, and administrative fees can be $250,000 per annum. So, it easy to see why this is a disincentive. OTC, there aren’t any fees to worry about. This particular market makes it easier for companies that can’t, or won’t meet the requirements to list on the markets.
The customer market is the place where dealers and clients interact. The inter-dealer market is where dealers trade amongst one another. With OTC markets, quotes are set up between the companies that buy/sell stocks from the exchange. Many investors consider OTC companies as much riskier investments, so buyer beware. The biggest hurdle with OTC stocks is the lack of transparency, credibility, and information related to the performance of the companies.
Can OTC Companies Jump to Exchanges?
Yes. But it all comes at a premium. There are significant rules and regulations that must be adhered to, in addition to financial matters that need to be taken care of. The benefit for companies is greater exposure to a broad-spectrum of the market, enhanced credibility, and the prestige of being listed at an official exchange. Companies that trade on the NASDAQ, the NYSE, the LSE, and other official exchanges generally reap the rewards through significant trading volumes and boosted pricing.
It is a lengthy, and expensive process for a company to make the switch from OTC to a central exchange. Applications are necessary, fees must be paid, and complete statements must be drafted. Outstanding shares and capital resources must be noted. Depending on the exchange in question, OTC companies fulfilling all the criteria may still be denied. Once a company is listed however, it is typically for life, although the share price must maintain a certain threshold and reporting must be undertaking at timely intervals. An important distinction needs to be made between a newly listed company and one that merely transfers from OTC to an exchange. In the latter, no IPO is undertaken.