Over-the-counter (OTC) refers to financial instruments traded directly between two parties, bypassing central exchanges or brokers. In the Indian securities market, the Over-The-Counter Exchange of India (OTCEI) is an electronic stock exchange comprising small- and medium-sized firms seeking access to international capital markets, including U.S. electronic exchanges like NASDAQ.
What is the Over-the-counter-market?
The over-the-counter (OTC) market is a decentralised financial marketplace where financial instruments are traded directly between two parties, often facilitated by a broker-dealer. Unlike centralised exchanges like the Nasdaq or the New York Stock Exchange, the OTC market operates without a physical trading floor or a centralised regulatory framework.
Unlisted stocks, which do not meet the requirements to be traded on major exchanges, form the primary assets in the OTC market. Companies that are unlisted automatically become public, allowing them to sell stocks without listing on traditional exchanges.
The OTC market often caters to smaller or emerging companies, providing them with a platform to raise capital. While investments in the OTC market can be risky due to limited regulatory oversight and liquidity, they also present opportunities for investors to discover undervalued assets with potential for high returns.
Understanding Over-the-Counter (OTC) markets
The OTCEI is based in Mumbai, India, and operates solely over a computer network. It arose primarily from small companies in India finding it difficult to raise capital through mainstream national stock exchanges because they could not fulfill the stringent requirements to be listed on them. The OTCEI has rules that are not as rigid as the national exchanges, allowing small companies to gain access to the capital they need to grow. The objective is that once they grow to a certain level and are able to meet the requirements to be listed on the national stock exchanges, they will make the switch over to the central stock exchanges like the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
How does the OTC market work?
The OTC (Over-The-Counter) market provides an alternative platform for companies to raise capital by selling securities directly to investors, bypassing traditional stock exchanges. These companies may not meet the listing requirements of major exchanges or prefer to avoid the associated costs and regulations.
Unlike the structured environment of stock exchanges, OTC trades occur through electronic networks overseen by broker-dealers. These broker-dealers act as market makers, quoting bid and ask prices for securities they hold in their own inventories. Investors can then purchase or sell OTC securities through these brokers.
Risks of OTC markets
While OTC markets offer advantages like lower listing fees and flexibility for companies, they also come with inherent risks for investors:
- Counterparty risk: In the absence of a central clearinghouse, investors rely on the counterparty's (broker-dealer's) creditworthiness to fulfill trade obligations.
- Limited transparency: Unlike exchanges with centralized platforms for trade data, OTC markets offer less transparency regarding pricing, volume, and trade details.
- Regulatory risk: OTC markets are generally subject to less stringent regulations compared to exchanges, making them more susceptible to manipulation and fraud.
- Price volatility: Lower liquidity and limited public information can lead to higher price volatility in OTC markets.
- Liquidity risk: Certain OTC markets may have limited trading volume, making it difficult to enter or exit positions at desired prices.
How to buy OTC stocks in India?
If you want to trade in over-the-counter stocks, you need to trade on the Over-The-Counter Exchange of India (OTCEI), which is a stock exchange designed solely for over-the-counter stocks. Like with stock exchanges, trading on the OTCEI is not directly possible. You need to buy or sell OTC stocks through registered brokers who deal in such stocks. Here are the options that you can choose from:
1. Full-service brokers
Full-service brokers are stockbrokers who facilitate investment in different financial instruments. They offer investment advice, recommendations, and help in managing your portfolio. Full-service brokers charge a fee for their service and might also levy brokerage on every transaction done through them. Most full-service brokers are able to offer over-the-counter stocks too to their customers. You would have to open a Demat account and a trading account with such brokers to trade in OTC stocks.
2. Discount brokers
Discount brokers are those that offer limited services and allow you to trade in stocks and other instruments for lesser charges than a full-service broker. Note that over-the-counter stocks are not available with all discount brokers. However, some brokers are authorised to allow their customers to trade in such stocks. So, if you have a Demat account with a discount broker, find out if the broker allows trading in OTC stocks.
Things to keep in mind when trading in OTC stocks
When trading in over-the-counter (OTC) stocks, there are several aspects that you need to keep in mind:
1. Low cost of investment
OTC stocks are generally cheaper than stocks listed on the recognised stock exchanges of India. This allows you to buy them in bulk with a small investment amount.
2. No transparency
OTC stocks often have lower transparency due to lenient reporting requirements. This means that publicly available information regarding the financials of the related company is also quite less.
3. Growth potential
OTC stocks may have growth potential as they are often of companies that are not listed on the recognised stock exchanges of India. These companies may be operating in interesting spheres, such as a popular technology or have a product that has scope for growth that investors are keen to invest in.
4. Potential of high risk
OTC stocks are riskier than stocks listed on the recognised stock exchanges of India. They have their own pricing mechanisms and may be low-priced. Therefore, it is important to do thorough research before investing in OTC stocks.
5. Low liquidity
OTC stocks have less liquidity than those listed on exchanges. The exchange stocks usually have a significantly lower trading volume and bigger spreads between the bid and ask prices. Therefore, OTC stocks are subject to more volatility.
Difference between OTC and Stock Exchanges
Here is a table showing the key differences between the OTC market and stock exchanges:
Parameter |
OTC market |
Stock exchange |
Definition |
Decentralised network for trading securities |
Centralised marketplace for trading securities |
Regulation |
Less stringent |
Heavily regulated |
Listing requirements |
No requirements |
Strict requirements to meet |
Transparency |
Lower transparency |
Higher transparency |
Liquidity |
Lower liquidity |
Higher liquidity |
Market size |
Smaller market |
Larger market |
Types of securities |
Smaller companies, debt securities |
Publicly traded stocks |
Trading hours |
24/7 |
Fixed hours (often 9:30 am to 4 pm) |
Market makers |
Frequently used |
Used to facilitate trades |
What are the 3 OTC Markets?
The OTC market is divided into three main segments, each catering to different types of companies and investor risk tolerances:
1. The Venture Market (OTCQB)
The Venture Market serves as a platform for young and growing companies. Its eligibility requirements are less stringent compared to the more established OTC markets, making it a stepping stone for emerging firms.
2. The Best Market (OTCQX)
This market is designed for well-established and reputable companies that meet high financial and operational standards. The OTCQX enforces strict reporting and transparency requirements, ensuring a relatively safer environment for investors.
3. The Pink Market
Commonly referred to as "pink sheets," the Pink Market is the riskiest segment. It comprises penny stocks, shell companies, and firms facing financial distress. With minimal regulatory oversight, this market is susceptible to fraud and poses significant risks for investors.
Another OTC segment, the grey market, operates without broker-dealer quotations and has limited access due to the lack of regulatory compliance and available financial information.
Advantages
Here are some key advantages of the OTC market that you should be aware of:
1. Diverse investment opportunities
Access to smaller companies: OTC markets provide a platform for smaller or emerging companies that may not meet the stringent listing requirements of major exchanges. This allows investors to explore and invest in a broader range of businesses.
2. Lower costs
Affordability: OTC stocks are often more affordable than those listed on major exchanges. This affordability can be appealing to investors with limited capital, enabling them to diversify their portfolio with a smaller investment.
3. Potential for high returns
Growth potential: OTC stocks are typically associated with companies that have significant growth potential. Investing in these stocks at an early stage can lead to substantial returns if the company experiences success and its stock value increases.
4. Less stringent regulatory requirements
Reduced regulatory hurdles: OTC-listed companies face fewer regulatory requirements compared to those listed on major exchanges. This flexibility can be advantageous for companies seeking capital without having to comply with the stringent regulations of larger exchanges.
Disadvantages
Let us understand some of the disadvantages of OTC trading:
1. Higher risk
OTC stocks are often more volatile than their exchange-listed counterparts. Lower liquidity and fewer regulatory constraints can result in larger price fluctuations, increasing the risk for investors.
2. Limited information and transparency
OTC-listed companies may not be obligated to provide as much financial information as those on major exchanges. This lack of transparency can make it challenging for investors to assess the true financial health and performance of these companies.
3. Lack of liquidity
OTC markets generally have lower liquidity, meaning there may be fewer buyers and sellers for a particular stock. This lack of liquidity can lead to wider bid-ask spreads and difficulty in executing trades at desired prices.
4. Potential for fraud
The less regulated nature of the OTC market can attract fraudulent activities. Investors should be cautious of "pump and dump" schemes, where manipulative practices artificially inflate a stock's price, only for insiders to sell off their shares at a profit.
5. Limited analyst coverage
OTC stocks often receive less coverage from financial analysts and media, making it challenging for investors to find comprehensive and reliable information for making informed investment decisions.
Conclusion
While the OTC market presents opportunities for diversification and potential high returns, it comes with higher risks and requires careful consideration. Investors should thoroughly research and assess the specific characteristics of OTC stocks before including them in their portfolios. Additionally, maintaining a balanced approach and understanding the unique dynamics of the OTC market are essential for mitigating risks and maximising potential returns.
