What is Over-the-Counter (OTC)?
Many stocks are traded on well-known stock exchanges such as Nasdaq or the New York Stock Exchange. However, certain securities are traded in decentralized marketplaces, commonly referred to as over-the-counter (OTC) markets. Stocks often end up trading on OTC markets if they don’t meet the rigorous listing criteria of major exchanges. Understanding how OTC trading operates and being aware of the considerations and risks involved before investing in OTC securities is essential for investors.
What is OTC?
OTC, or over-the-counter, refers to the process of trading securities that are not listed on major stock exchanges. This type of trading occurs through decentralized networks, where broker-dealers facilitate the transactions. Securities commonly traded OTC include:
- Penny stocks, typically priced under $5 per share.
- International stocks and American Depository Receipts (ADRs), which represent shares in foreign companies.
- Stocks delisted due to bankruptcy or failure to meet exchange requirements.
- Bonds.
- Financial derivatives like forwards and swaps.
Trading OTC securities can feel similar to trading on major exchanges due to electronic platforms, and many are accessible through standard brokerage accounts. However, OTC trading lacks the stringent reporting and transparency standards of major exchanges, necessitating increased caution and research from investors.
The OTC Markets Group is a public company that operates an open market for around 12,000 OTC securities across three exchanges:
- OTCQX Best Market: The highest tier, requiring strict transparency, including annual audited financials and prompt material news disclosure. Penny stocks, bankrupt companies, shell, and blank-check companies are excluded.
- OTCQB Venture Market: For emerging companies, with a minimum bid price of $0.01. This market demands annual audited financials and current reports to U.S. regulators like the SEC. Bankrupt companies are not allowed.
- Pink Sheets: The riskiest tier, with minimal reporting requirements and no minimum financial criteria.
Securities not traded via OTC Markets Group are categorized as grey market securities. These are unregulated, with no quoted prices from broker-dealers.
Risks and rewards of OTC trading
Investing in OTC (over-the-counter) securities isn’t inherently risky; in fact, it can offer valuable opportunities. For instance, many highly successful international companies opt to trade OTC in the U.S. rather than on major U.S. exchanges to bypass additional regulatory demands. OTC markets also provide a chance to invest in promising early-stage companies that might not want to incur the costs associated with listing on the NYSE or Nasdaq.
However, there are significant risks associated with OTC securities. One key issue is that they are often not heavily traded, leading to limited liquidity. This means you might struggle to find a buyer when you wish to sell your shares. The low trading volume can result in high price volatility, with wide bid/ask spreads due to the imbalance in supply and demand.
Another concern is the relaxed disclosure requirements and, in some cases, a complete lack of financial standards. This environment can include companies without a solid track record or those delisted from major exchanges due to bankruptcy or financial issues. The reduced transparency in OTC markets can make investors more susceptible to fraud. For example, in pump-and-dump schemes, fraudsters artificially inflate a company’s share price with misleading information, then sell off their shares at a profit, leaving unsuspecting investors with losses.
Examples of OTC securities
Nestle, the renowned Swiss food and beverage company (trading under the ticker NSRGY with a 1.24% increase), is a prime example of a large corporation trading OTC in the U.S. Boasting a market capitalization of $300 billion and a consistent dividend history, Nestle is listed on the SIX Swiss Stock Exchange. However, in the U.S., its shares are accessible only as American Depository Receipts (ADRs) on the Pink Sheets.
On the other hand, Revlon serves as an example of a company facing challenges while trading OTC. This well-known cosmetics brand was removed from the NYSE in October, four months following its Chapter 11 bankruptcy filing. Despite appealing against the delisting, Revlon’s shares fell over 50% after the NYSE rejected its appeal. Currently, Revlon’s shares are traded on the Pink Sheets under the ticker symbol OTCMKTS: REVRQ. The “Q” in the ticker symbol indicates that the company is undergoing bankruptcy proceedings.