OTC is the acronym for Over the Counter. In the business and financial world, Over the Counter trading is also known as trading off of the exchange. Such OTC trading goes on when financial instruments of various kinds, including stocks, commodities, bonds, or derivatives, are traded literally between the buying and selling party themselves, without having an exchange in the middle of the transaction.
Over the Counter trading can be said to be the opposite of exchange trading. Exchange trading happens in facilities or over electronic market places that are specially created for the trading of these instruments. Stock exchanges and futures exchanges are the places that exchange trading takes place and Over the Counter trading does not.
Within the United States, Over the Counter stock trading is done via market makers who ensure that there are markets in both Pink Sheet and OTCBB, or bulletin boards, securities. They do this through the utilization of quotation services that are between dealers, like Pink Quote, run by the Pink OTC Markets, and OTC Bulletin Board for the OTCBB. While Over the Counter stocks typically do not either list or trade on any form of stock exchange, stocks that are listed on exchanges may be traded on the third market over the counter.
OTCBB quoted stocks have to follow the reporting rules as set out by the United States SEC, or Securities and Exchange Commission, regulatory body. Pink Sheet stocks are not governed by such reporting requirements. Still other stocks that are traded as OTCQX meet different disclosure guidelines that they are permitted to work under in the OTC Pink sheet markets.
OTC can also relate to contracts created between two entities. In these contracts, the two parties concur on the way that a specific trade will be settled at a certain future point. These typically come from investment banks and go out to their own clients. Good examples of these types of OTC arrangements are swaps and forwards. Such contracts are typically arranged over the phone or via computer. Derivative OTC contracts fall under the governance of an agreement provided by the International Swaps and Derivatives Association. This type of OTC market is sometimes called the Fourth Market.
In the Financial Crisis of 2007-2010, many of these OTC derivative contracts created and wreaked havoc in international financial markets specifically because they were traded over the counter, and no one exactly knew what risk and credit were entailed in the contracts that totaled in the tens of trillions of dollars and were made between mysterious partners. To address this critical problem, the NYMEX, or New York Mercantile Exchange, set up a mechanism for clearing many of the most frequently traded energy derivatives that were previously traded only OTC. Now, many of these customers can simply hand over the trade to the exchange’s clearing house ClearPort. This removes the dangers associated with both performance and credit risk that were previously seen in these OTC transactions. Other exchanges are endeavoring to do the same thing to try to take derivatives and credit default swap contracts away from the shadowy world of Over the Counter trading. The G20, or Group of Twenty Industrialized and Industrializing nations, is considering ways of rewarding parties for bringing such OTC derivative transactions onto regulated exchanges as well.