The trading of securities between two counter-parties executed outside of formal exchanges
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Over-the-counter (OTC) is the trading of securities between two counterparties executed outside of formal exchanges and without the supervision of an exchange regulator. OTC trading is done in over-the-counter markets (a decentralized place with no physical location), through dealer networks.
Contrary to trading on formal exchanges, over-the-counter trading does not require the trading of only standardized items (e.g., clearly defined range of quantity and quality of products). Also, prices are not always published to the public. OTC contracts are bilateral, and each party could face credit risk concerns regarding its counterparty.
OTC securities comprise a wide range of financial instruments and commodities. Financial instruments traded over-the-counter include stocks, debt securities, and derivatives. Stocks that are traded over-the-counter usually belong to small companies that lack the resources to be listed on formal exchanges. However, sometimes even large companies’ stocks are traded over-the-counter.
Derivatives represent a substantial part of over-the-counter trading, which is especially crucial in hedging risks using derivatives. The lack of limitations on the quantity and quality of traded items allows the parties involved in the trading to tailor the specifications of the contracts in the transaction to the risk exposure. Thus, these instruments could be used for a “perfect hedge.”
In the United States, over-the-counter trading of stocks is carried out through networks of market makers. The two well-known networks are managed by the OTC Markets Group and the Financial Industry Regulation Authority (FINRA). These networks provide quotation services to participating market dealers. The trades are executed by dealers online or via telephone.
The Importance of OTC in Finance
While over-the-counter markets remain an essential element of global finance, OTC derivatives possess exceptional significance. The greater flexibility provided to market participants enables them to adjust derivative contracts to better suit their risk exposure.
Also, OTC trading increases overall liquidity in financial markets, as companies that cannot trade on the formal exchanges gain access to capital through over-the-counter markets.
However, OTC trading is exposed to numerous risks. One of the most significant is counterparty risk – the possibility of the other party’s default before the fulfillment or expiration of a contract. Moreover, the lack of transparency and weaker liquidity relative to the formal exchanges can trigger disastrous events during a financial crisis. The flexibility of derivative contracts design can worsen the situation. The more complicated design of the securities makes it harder to determine their fair value. Thus, the risk of speculation and unexpected events can hurt the stability of the markets.
For example, notorious CDOs and synthetic CDOs that caused a significant impact on the global financial crisis in 2007-2008 were traded only in the OTC markets.
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