What are OTC Stocks?
When buying and selling stock, most investors will find themselves submitting orders through their broker to a specific exchange: usually the NASDAQ or NYSE. These are two marketplaces for established securities. If you’re a small- or micro-cap investor, you’re likely more familiar with OTC stocks. The Over-the-Counter (OTC) marketplace is a stock exchange for small companies that don’t qualify for listing on major exchanges.
The world of OTC stocks is vast and can include all manner of companies. Some are too small to pay the listing fee for one of the major exchanges. Others are foreign companies that don’t meet certain financial reporting requirements. There are even companies that formerly listed on the NASDAQ or NYSE, but whose shares have fallen below the listing threshold ($1). Here’s a closer look at OTC stocks and what investors need to know about them.
Exchanges vs. OTC Markets
Securities change hands in one of two ways: through an exchange, where they’re processed by market makers, or over the counter, where they’re processed by broker-dealers.
There’s a high level of transparency associated with exchanges. They’re regulated by financial authorities, and there are specific requirements that standardize the trading process. Trades happen quickly and efficiently thanks to the high liquidity maintained by market makers. The entire exchange environment is conducive to open, accessible, reliable trades.
OTC markets are more erratic and can involve much less transparency. Broker-dealer networks are decentralized, and negotiations for bid-ask happen directly between brokers, which means prices aren’t posted until the transaction completes. There are fewer checks and balances, since unlisted stock trades aren’t subject to the standards of a formal exchange like the NASDAQ or NYSE. It’s also much cheaper to list (~$14,000) in an OTC marketplace.
Types of Companies Listed OTC
As mentioned, there are a wide range of companies that list as OTC stocks. Their reasons vary depending on the situation. Some of the most common types of OTC stocks include:
- Foreign companies. Many foreign companies choose not to list on American stock exchanges due to the cost and rigorous listing requirements. Instead, they list in OTC markets. Some of the best examples include companies like Tencent Holdings (OTC: TCTZF) and Nestle (OTC: NSRGF)
- Small companies. It can cost tens of thousands of dollars to list on the NASDAQ or NYSE, and even more than that to maintain an annual listing. Many small companies simply don’t have that amount available to them. Their stocks trade OTC at a much lower cost, to ensure access to shareholder capital.
- De-listed companies. Companies fallen on turbulent times can see their stock price sink below $1. When they do, it triggers de-listing from major exchanges. These companies trade OTC until they’re able to re-list… or until they declare bankruptcy. Some companies also voluntarily de-list to trade OTC, then later re-list.
- American Depositary Receipts (ADRs). Not every company offers shares to foreign investors. Instead, banking institutions issue ADRs as a way to attract international investors. Because they’re not technically shares of common stock, ADRs change hands in OTC markets.
- Debt securities. Bonds aren’t usually traded via major exchanges. Instead, debt instruments change hands in OTC markets, where there’s no additional cost to list them. The same is true for derivatives, which trade OTC simply because they’re not representative of a tangible security.
Collectively, investors refer to OTC stocks as “Pink Sheets.” Today, there are nearly 10,000 pink sheet securities traded OTC.
An Introduction to OTC Networks
OTC stock trades happen across broker-dealer networks. In the United States, most of these networks belong to the OTC Markets Group (OTC: OTCM). OTC Markets Group provides pricing information and liquidity across three main networks:
- OTCQX Market, representing 400 top-tier OTC stocks
- OTCQB Market, representing 900 venture-stage companies
- Pink Open Market, representing all other unlisted securities
Each OTC network offers a different level of risk and reward to investors. OTCQX, for example, is primarily established companies that choose not to list on a traditional exchange. Conversely, the Pink Open Market is more of a Wild West, rife with penny stocks subject to pump-and-dump schemes.
While all OTC markets—including those not managed by OTC Markets Group—represent the same level of accessibility, their levels of risk vary. Investors may not find complete financial reporting, liquidity or transparency from the companies they’re interested in. It’s important to have a knowledgeable handle on investing if you’re planning on dabbling in OTC markets.
The Risks Associated with OTC Stock Trades
OTC stocks come with no shortage of risk attached to them. While OTC markets enable greater accessibility to companies not listed, it’s important to beware of several important pitfalls:
- Without market makers, some OTC stocks can fall into low-volume liquidity traps.
- Less regulation means less transparency in financial documentation and price reporting.
- OTC stocks tend to move with high volatility, pending news and other market factors.
- Pumping can inflate stock prices and leave eager investors holding the bag after a dump.
The high upside of OTC stocks is often enough to lure eager investors. It’s important to evaluate companies as thoroughly as possible before buying shares OTC, and to understand the risks that accompany trades outside of traditional exchanges.
OTC Markets Play an Important Role in Investing
Every day, as many as six billion shares change hands in OTC markets, representing as much as $1.2 billion. While this pales in comparison to the sums facilitated on the NASDAQ or NYSE, OTC markets play a special role in keeping markets free, open, and accessible.
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Not every company has the means or ability to list on a traditional exchange. Those that can’t or won’t will find the capital they need by offering OTC stocks to investors. For many, it’s exactly the support they need on their way up to greater market capitalization.