OTC market and Exchange market are two different marketplaces where traders buy and sell different financial instruments/assets like currencies, stocks, etc. As you embark on your journey towards becoming an online trader, choosing the right market to trade holds a great deal of importance. Let’s dive right in!
What does OTC Market mean in Trading?
The OTC market or (over-the-counter) market in trading is a decentralized financial market facilitating the exchange of financial instruments between two parties through a broker-dealer. In this type of trading, transactions occur directly between the participants, without the involvement of a centralized exchange like the New York Stock Exchange (NYSE) or Nasdaq. Unlike traditional exchanges, the OTC market lacks a physical location and operates electronically in a decentralized manner.
OTC trading is characterized by lesser regulatory oversight compared to exchange-based trades, which brings about various opportunities but also entails certain risks that traders should be mindful of. When engaging in OTC trading with a provider, you’ll typically encounter two listed prices: a single buy price and a single sell price. This differs from on-exchange trading, where multiple buy and sell prices from various parties are visible.
What are Exchange-Traded Markets?
Exchange-traded markets refer to financial markets wherein centralized exchanges facilitate the trading of securities, commodities, and various financial instruments. These markets bring together buyers and sellers to conduct transparent and regulated asset transactions.
Acting as a central marketplace, the exchange enables participants to buy, sell, and exchange securities at either current market prices or predetermined rates. The exchange can take the form of a physical trading location, such as premises, or an electronic platform, like a website.
The primary function of an exchange is to ensure fair and orderly trading while efficiently disseminating price information for all securities listed on the exchange. By providing a platform, exchanges offer companies, governments, and other entities the opportunity to sell securities to the investing public, facilitating capital raising for businesses. Regulatory bodies implement strict market regulations to oversee and safeguard brokers, intermediaries, and investors, ensuring market integrity.
Trading on OTC Market VS Trading on Exchange Market
To gain a better understanding of the distinction between the OTC market and the exchange market, let’s delve into a practical scenario.
Imagine Mr. X attempting to sell a house In one approach, he can enlist the aid of a real estate broker who operates within a regulated framework, adheres to established rules, and charges a fee for linking him with potential buyers. In an alternative approach, he could opt to independently advertise the property with a visible "For Sale" sign and search for buyers himself. This independent approach loosely mirrors an OTC trade, whereas the involvement of a real estate broker draws parallels to exchange-traded markets.
Exchanges were once physical like NYSE, where traders made deals in pits wearing striped jackets. With exchange trading, all transactions go through an official central organization, connecting buyers and sellers securely. Products are standardized and follow strict rules.
In contrast, over-the-counter (OTC) trading is decentralized, with no single mediator. Participants trade assets directly, electronically, making it more convenient and often cheaper. OTC product prices are market-driven, following supply and demand, which affects market liquidity – the number of people trading an asset at a given time, influencing trade availability.
| Aspect | OTC Market | Exchange Market |
| Definition | A market where securities are traded directly between two parties, without the use of an exchange. | A centralized platform where buyers and sellers can trade securities, such as stocks and derivatives, according to pre established rules and regulations. |
| Market Participants | Typically, financial institutions, hedge funds, and large investors. | Retail and institutional investors, market makers, and authorized participants. |
| Trading Hours | Continuous, 24/5 | Limited to specific exchange hours |
| Price Discovery | Based on direct negotiations between buyer and seller. | Based on supply and demand, as determined by the bid and ask prices of multiple market participants. |
| Transparency | Low, as prices are only known to the two parties involved in the transaction. | High, as all trades are publicly disclosed and can be monitored in real-time. |
| Liquidity | Depends on the size and frequency of trades between parties. | Generally higher, due to the large number of market participants. |
| Regulation | Minimal, as there is no central authority overseeing the market. | Regulated by government agencies, such as the SEC or CFTC. |
| Execution Speed | Fast, as transactions can be completed directly between parties. | Can be slower, due to the need for price matching and the potential for network delays. |
| Costs | Typically higher, due to the absence of price competition. | Lower, due to the presence of price competition and the ability to take advantage of volume discounts. |
| Accessibility | Limited to large financial institutions and high net-worth individuals. | Generally, more accessible, with many online brokerages offering. retail investors the ability to trade on major exchanges. |
What Instruments can you trade on OTC Market?
The most frequently traded Over-the-Counter (OTC) markets encompass forex, shares, debt securities, and financial instruments like Contracts for Difference (CFDs) that are directly purchased from dealers, often through electronic trading platforms.
OTC Forex Trading:
The OTC forex trading market stands out as the most popular among OTC markets, facilitating currency exchanges through a network of banks, brokers, and individuals worldwide. Since forex trading is not dependent on exchange operating hours, positions can be opened and closed 24/5, five days a week.
One drawback of the decentralized nature of the FX OTC market is the difficulty in accurately determining trading volume. Unlike on-exchange assets, comprehensive trading volume information is less readily available. The most commonly cited FX volume figure comes from the triennial Central Bank Survey.
OTC shares, also known as ‘unlisted stocks,’ typically belong to smaller companies that do not meet the listing requirements of major stock exchanges. Reasons for not meeting these requirements include insufficient market capitalization, a share price below a certain threshold, or facing financial troubles.
Some companies may prefer to avoid the high fees charged by exchanges, such as the NYSE, which can amount to $250,000 annually. Nevertheless, even some larger companies may choose to trade OTC shares, alongside smaller ones like penny stocks. Platforms such as OTCQX, OTCQB, and OTC Pink (formerly OTC Bulletin Board and Pink Sheets) serve as electronic systems that provide traders with quotes, prices, and trade volumes despite not being centralized exchanges.
OTC Debt Securities Trading:
Debt securities, like bonds, are traded over the counter through investment banks. Unlike company shares, bonds are not traded on exchanges due to their diverse issuers, each offering unique maturities, values, and credit ratings.
Bonds are generally less liquid than other OTC assets, with liquidity depending on the issuer and the firm’s credit history.
OTC Derivative Products:
Derivative products like forward contracts, swaps, and CFDs can also be traded OTC. Brokers play a key role in organizing the supply and demand of derivatives within their organizations, setting prices, and executing trades. In essence, CFD Trading and other derivatives are not exchange-traded; instead, they are contractual agreements directly made between traders and their providers.
Pros and Cons of Trading in the OTC Market
OTC trading presents various advantages and disadvantages that traders should weigh carefully:
Advantages of the OTC Market:
- OTC markets offer several advantages, particularly the ability to trade in customizable sizes. This flexibility gives traders greater control over their volumes. A
- dditionally, OTC trading provides access to otherwise inaccessible markets. Through OTC derivatives, traders can take positions on various assets without owning them, opening up new opportunities.
- While OTC markets were once criticized for low liquidity, significant improvements have been made to address this, resulting in smoother trade executions.
- Electronic quotation systems have played a key role in improving the flow of information available to traders.
Disadvantages of the OTC Market:
- Counterparty risk is a significant concern in OTC markets. It occurs when one party fails to meet contractual obligations, resulting in a default. The absence of regulation in decentralized trading contributes to this risk.
- Financial exchanges, on the other hand, are regulated entities that offer a higher level of safety. Although there may be limitations on the types of securities listed, transactions are standardized in terms of quantity and quality. This ensures that buyers receive what they pay for. In contrast, OTC prices are undisclosed until the trade is completed, which poses the risk of unfavorable execution prices.
- OTC markets also tend to have higher volatility and unpredictability. This is due to the large number of traders and the lack of regulatory oversight. While this volatility may present opportunities for short-term traders, it is important to implement a risk management strategy to guard against market manipulation. OTC markets are more susceptible to such practices.
How CFD trading and OTC markets are connected?
A Contract for Difference (CFD) is a popular and straightforward financial agreement where two parties exchange the difference in prices between an asset’s opening and closing. CFD trading, closely connected to Over-the-Counter (OTC) trading, involves direct trades between the trader and the broker.
This OTC market allows investors to trade based on price differences without owning the underlying asset. When taking a long CFD position, the broker assumes the short position and vice versa. The broker provides CFD prices, which may slightly differ from actual market prices due to factors like spreads and fees.
Read Is CFDs the Cheapest way to trade Stocks, Crypto, and Gold?
Why Forex is the most popular OTC market?
Forex market stands as the most popular OTC market, facilitating currency exchanges worldwide through a vast network of banks, brokers, and individuals. Unlike traditional exchanges, forex trading operates outside centralized platforms, permitting round-the-clock trading, unbounded by the limitations of formal exchanges like the New York Stock Exchange.
Numerous factors contribute to forex’s unparalleled popularity as an OTC market:
- Liquidity: With a staggering daily volume of over $7 trillion, the forex market reigns as the world’s largest financial market, ensuring heightened liquidity. Traders can swiftly and fairly trade currencies, capitalizing on market opportunities.
- Accessibility: Forex trading boasts a low entry barrier, catering to a diverse range of traders, including central banks and retail investors. Furthermore, the market’s 24/5 availability enables participants to engage at their convenience.
- Flexibility: Traders in the forex market enjoy exceptional flexibility, utilizing various strategies for trading and hedging currencies. This adaptability empowers traders to respond to dynamic market conditions and seize advantageous situations.
- Decentralization: In contrast to centralized exchanges, the forex market operates in a decentralized manner, contributing to improved market efficiency, transparency, and additional opportunities for traders to profit from currency fluctuations tied to the global economy.
There are plentiful free courses available online to learn forex trading. However, it is advised to acquire knowledge from reliable sources such as reputable trading companies or seasoned professional traders.
