Macro Mondays: OTC Markets
Yes, I am aware that it is Tuesday, but since Monday was a holiday, don't think you aren't going to get away with some educational tips brought to you every Monday! This week I thought we'd discuss something that even I am still learning - the OTC marketplace.
I have met many investors who had stocks in their portfolios that trade on the OTC markets, and more often than not have no idea why they are holding onto them. It could be a company they once worked for, or a startup company created by a relative or friend - they are small shares with no track record, low liquidity, and low trading volumes, so they have a hard time knowing if the stocks are even worth anything.
I will say if you own penny stocks or are even considering going into the OTC markets, PLEASE consult a professional, fiduciary advisor to help you navigate these investments. They are extremely risky and more often than not will go bankrupt before they can ever be listed on a major exchange. But that is a different story for a different day.
Let's just take a quick look at what Investopedia has to say regarding the OTC markets...
What is an 'Over-The-Counter Market'?
A decentralized market, without a central physical location, where market participants trade with one another through various communication modes such as the telephone, email and proprietary electronic trading systems. An over-the-counter (OTC) market and an exchange market are the two basic ways of organizing financial markets. In an OTC market, dealers act as market makers by quoting prices at which they will buy and sell a security or currency. A trade can be executed between two participants in an OTC market without others being aware of the price at which the transaction was effected. In general, OTC markets are therefore less transparent than exchanges and are also subject to fewer regulations.
What are 'Over-The-Counter Markets' Used For?
OTC markets are primarily used to trade bonds, currencies, derivatives and structured products. They can also be used to trade equities, such as the OTCQX, OTCQB and OTC Pink marketplaces (previously the OTC Bulletin Board and Pink Sheets) in the U.S. Broker-dealers that operate in the U.S. OTC markets are regulated by the Financial Industry Regulatory Authority (FINRA).
OTC markets are typically bifurcated into the customer market – where dealers
trade with their clients such as corporations and institutions – and the interdealer market, where dealers trade with each other. The price a dealer quotes to a client may very well differ from the price it quotes to another dealer, and the bid-ask spread may also be wider in the case of the former than in the latter.
While OTC markets function well during normal times, their lack of transparency can cause a vicious circle to develop during times of financial stress, as was the case during the 2007-08 global credit crisis. Mortgage-backed securities and other derivatives such as CDOs and CMOs, which were traded solely in the OTC markets, could not be priced reliably as liquidity totally dried up in the absence of buyers. This resulted in an increasing number of dealers withdrawing from their market-making functions, exacerbating the liquidity problem and causing a worldwide credit crunch. Among the regulatory initiatives undertaken in the aftermath of the crisis to resolve this issue was the use of clearinghouses for post-trade processing of OTC trades.