BROWSE

Over the Counter Trading

Definition

Over-the-counter or off-exchange trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price. In an OTC trade, the price is not necessarily published for the public.

Any security that is traded anywhere, other than a formal exchange such as PSX, NASDAQ, Nikkie etc, is referred to as an OTC (Over-The-Counter) Trade or an Off Exchange Trade.

Bilateral Trade

Typically such trade is bilateral since it takes place between two individuals or organizations without the support or supervision of a stock exchange. This is because quite unlike a formal (Stock) exchange, OTC trading is never centered on a specific place or location.

Nevertheless, OTC trade just like its Stock Exchange counterpart deals with the buying and selling of financial instruments (such as stocks of PL companies), commodities as well as derivatives of all similar products.

The OTC market does not suffer from the limitations of the Stock exchange such as standardized product trading, and a markedly narrow range of financial deliverables whose quantity and identity has been pre-determined by the exchange for transparency related reasons. The two parties undertaking the OTC trade may for example agree on a very high quantity that would be above the limits of the conventional Stock exchange. However, the associated risks corresponding to such a trade are far higher than trading at a physical exchange governed by its own specific set of laws, rules and regulations.

Less formal but more organized

OTC traders while being a lot less formal than its exchange counterpart, is still pretty well organized. Many dealers have their own networks of trading relationships and customers who prefer to deal with them rather than the exchange.

Sole responsibility of the traders

A crucial aspect of OTC trading is that settlements and clearing of all trading activity is the sole providence of the buyer and the seller, whereas in exchange transactions, the actual trades are guaranteed by the exchange by default, thereby decreasing the risks incurred.

Interdealer market

Another characteristic of OTC trading is the Interdealer market where dealers both quote and bid prices to each other and in this way lower their total risks by involving other dealers to their sales. They can also simply call each other to get multiple quotes and are able to price their product accordingly. A lay customer on the other hand would have to rely on his specific dealer for a quote since it is unlikely that other dealers would be willing to divulge information to relative strangers.


Further Reading


Determinants of bid-asked spreads in the over-the-counter market
www.sciencedirect.com [PDF]
… Demsetz (1968) to the price for effecting immediate transfers of title to shares (bid-asked spreads), is used to analyze the determinants of spreads in the over-the-counter … with spreads, mcasurcs the dealers' cost of portfolio diversification and their cost of trading with insiders …

Can the financial markets privately regulate risk?: The development of derivatives clearinghouses and recent over-the-counter innovationsCan the financial markets privately regulate risk?: The development of derivatives clearinghouses and recent over-the-counter innovations
www.jstor.org [PDF]
… Demsetz (1968) to the price for effecting immediate transfers of title to shares (bid-asked spreads), is used to analyze the determinants of spreads in the over-the-counter … with spreads, mcasurcs the dealers' cost of portfolio diversification and their cost of trading with insiders …

Over‐the‐counter marketsOver‐the‐counter markets
onlinelibrary.wiley.com [PDF]
… Demsetz (1968) to the price for effecting immediate transfers of title to shares (bid-asked spreads), is used to analyze the determinants of spreads in the over-the-counter … with spreads, mcasurcs the dealers' cost of portfolio diversification and their cost of trading with insiders …

Valuation in over-the-counter marketsValuation in over-the-counter markets
academic.oup.com [PDF]
… Demsetz (1968) to the price for effecting immediate transfers of title to shares (bid-asked spreads), is used to analyze the determinants of spreads in the over-the-counter … with spreads, mcasurcs the dealers' cost of portfolio diversification and their cost of trading with insiders …

Over-the-counter derivatives and systemic risk to the global financial systemOver-the-counter derivatives and systemic risk to the global financial system
www.nber.org [PDF]
… Demsetz (1968) to the price for effecting immediate transfers of title to shares (bid-asked spreads), is used to analyze the determinants of spreads in the over-the-counter … with spreads, mcasurcs the dealers' cost of portfolio diversification and their cost of trading with insiders …

Automated over-the-counter derivatives trading systemAutomated over-the-counter derivatives trading system
patents.google.com [PDF]
… Demsetz (1968) to the price for effecting immediate transfers of title to shares (bid-asked spreads), is used to analyze the determinants of spreads in the over-the-counter … with spreads, mcasurcs the dealers' cost of portfolio diversification and their cost of trading with insiders …

Counterparty risk externality: Centralized versus over-the-counter marketsCounterparty risk externality: Centralized versus over-the-counter markets
www.sciencedirect.com [PDF]
… Demsetz (1968) to the price for effecting immediate transfers of title to shares (bid-asked spreads), is used to analyze the determinants of spreads in the over-the-counter … with spreads, mcasurcs the dealers' cost of portfolio diversification and their cost of trading with insiders …

Endogenous intermediation in over-the-counter marketsEndogenous intermediation in over-the-counter markets
www.sciencedirect.com [PDF]
… Demsetz (1968) to the price for effecting immediate transfers of title to shares (bid-asked spreads), is used to analyze the determinants of spreads in the over-the-counter … with spreads, mcasurcs the dealers' cost of portfolio diversification and their cost of trading with insiders …

Regulating the invisible: the case of over-the-counter derivativesRegulating the invisible: the case of over-the-counter derivatives
heinonline.org [PDF]
… Demsetz (1968) to the price for effecting immediate transfers of title to shares (bid-asked spreads), is used to analyze the determinants of spreads in the over-the-counter … with spreads, mcasurcs the dealers' cost of portfolio diversification and their cost of trading with insiders …

Relationship Trading in Over‐the‐Counter MarketsRelationship Trading in Over‐the‐Counter Markets
onlinelibrary.wiley.com [PDF]
… Demsetz (1968) to the price for effecting immediate transfers of title to shares (bid-asked spreads), is used to analyze the determinants of spreads in the over-the-counter … with spreads, mcasurcs the dealers' cost of portfolio diversification and their cost of trading with insiders …



Q&A About Over the Counter Trading


Who trades in OTC markets?

The OTC market includes individual investors and institutional investors such as pension funds and hedge funds.

What is Over the Counter Trading?

Any security that is traded anywhere, other than a formal exchange such as PSX, NASDAQ, Nikkie etc., is referred to as an OTC (Over-The-Counter) Trade or an Off Exchange Trade. Typically such trade is bilateral since it takes place between two individuals or organizations without the support or supervision of a stock exchange. This is because quite unlike a formal (Stock) exchange, OTC trading is never centered on a specific place or location. Nevertheless, OTC trade just like its Stock Exchange counterpart deals with the buying and selling of financial instruments(such as stocks of PL companies),commodities as well as derivativesof all similar products. The OTC market does not suffer from the limitations of the Stock exchange such as standardized product trading, and a markedly narrow range of financial deliverables whose quantity and identity has been pre-determined by the exchange for transparency related reasons. The two parties undertaking the OTC trade may for example agree on a very high quantity that would be above the limits of the conventional Stock exchange. However, the associated risks corresponding to such a trade are far higher than trading at a physical exchange governed by its own specific set of laws, rules and regulations.

How does one trade in OTC markets?

One can either call a broker to execute an order or use a computerized trading system to place orders electronically over a network such as Bloomberg's Tradebook or Reuters Dealing 3000Xtra systems.

What are some examples of products traded on OTC markets?

Products traded on OTC markets include commodities (such as grains), financial instruments (including stocks), derivatives of such products (such as futures contracts), and options on these products (for example). Products traded on exchanges must be well standardized. This means that exchanged deliverables match a narrow range of quantity, quality, and identity which is defined by the exchange and identical to all transactions of that product. This is necessary for there to be transparency in trading. The OTC market does not have this limitation; they may agree on an unusual quantity for example small b sup id="citeref-FOOTNOTEMcCrank2141-" class="reference" &91;1&93; . In OTC, market contracts are bilateral (i.e., the contract is only between two parties), and each party could have credit risk concerns with respect to the other party. The OTC derivative market is significant in some asset classes because it allows institutions to trade without revealing their positions

What are some characteristics unique to Over The Counter Trading?

Some characteristics unique to Over The Counter Trading include but are not limited to; no centralized location for trades; no standardized product trading; no pre-determined quantity limits; greater risk involved in comparison with stock exchanges due to less regulation; more flexible terms can be agreed upon between traders compared with those offered by exchanges which have standardized contracts in place; there may be fewer participants in comparison with stock exchanges due to lesser liquidity available in most cases at least initially when new products are being introduced into markets through over-the counter trades before they become popular enough for inclusion into regular stock exchanges where they can then enjoy greater liquidity levels

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