The OTC market provides an alternative to stock exchange listing for securities of issuers that either choose not to be listed on a U.S. stock exchange or do not meet the relevant listing requirements. The term ‘OTC security’ is a catch–all phrase for any security that is not listed on a U.S. stock exchange.
OTC market structure is very similar to other equity security markets. A key difference, however, is in the actual trading process, which will be explained in Part 2 – Trading. The five participants in the OTC market include:
- Inter-dealer Quotation/Trading Systems (e.g., OTC Markets Group’s OTC Link platform)
These participants each perform different functions and each has different constituents. Understanding how they work together and compete against each other to create a more efficient OTC marketplace will help make understanding more complex market concepts easier.
Companies (Issuers) – Companies create and sell securities in the market to raise capital, complete an acquisition and/or allow selling shareholders to exit their investments.
Companies may issue and sell shares in the OTC market pursuant to the safe-harbor guidelines under SEC Rule 144 and 144A.
In the OTC market, companies that qualify and are current in their financial disclosure may choose to apply their currently tradeable security(ies) for OTCQX. Companies may also choose to provide adequate disclosure either to regulators or OTC Markets Group in order to be classified in a ‘Current’ OTC Market Tier.
Liquidity follows transparency. Companies that provide current disclosure either through a regulator or directly to OTC Markets Group experience significantly greater levels of liquidity, improved price discovery, and more efficient trading.
Investors – Investors in the OTC market vary in their knowledge and experience from large institutional money managers to retail investors. The goal of all of these investors is the same – to generate returns from their investment. OTC Markets Group facilitates information transparency in the OTC market by aggregating and disseminating real-time broker-dealer quote information and operating the platform for companies to provide financial and other corporate disclosure for investors.
All investors must execute their OTC securities transactions (buy and sell orders) through a FINRA®-registered broker-dealer. More information on trading is available in Part 2 – Trading.
Broker-Dealers – FINRA registered broker-dealers may participate in the OTC market by executing client orders and principal orders. Broker-dealers earn revenues from commissions charged on orders, the bid (buy) and ask (sell) spread (the difference between what an investor is willing to buy and sell a security), and principal trading (investing the firm’s capital in an investment/trading strategy).
Broker-dealers often receive buy and sell orders that ‘match’ – meaning, someone is willing to sell a security for the same price someone else is willing to buy the same security. In this situation, broker-dealers will execute the trade “internally”. This is preferable for broker-dealers because they receive commissions on both the buy and sell-side of the trade. In executing client orders, broker-dealers may also buy or sell for their own (principal) account, at their own risk. If, however, there is no match for a trade or a broker-dealer does not wish to trade for their own account then a broker-dealer must find another broker-dealer willing to trade that particular security.
Regardless of the broker-dealer’s decision regarding a customer order, they must comply with FINRA’s ‘Best Execution’ Rule 2320. ‘Best Execution’ and other customer protection rules are discussed in more detail in Part 3 – Regulation.
There is no central ‘exchange’ in the OTC market; therefore, broker-dealers must communicate and trade directly with other broker-dealers. In order to notify other broker-dealers that they are willing to trade a security at a particular price, broker-dealers post their ‘quotes’ on an Inter-dealer Quotation system such as OTC Link. The aggregation and ranking of these quotes defines the ‘market’ for a security. The highest ‘bid’ (purchase price) and lowest ‘ask or offer’ (sale price) becomes the ‘inside market’ or NBBO – the National Best Bid and Offer.
If a broker-dealer decides to trade they can communicate with other broker-dealer(s) using OTC Link – OTC Markets Group’s electronic messaging and trade negotiation system – or they may contact the broker-dealer through other means of communication and negotiate the trade.
Regulators – The OTC market and broker-dealers’ activities in the market are regulated by The Financial Industry Regulatory Authority (FINRA), the U.S. Securities and Exchange Commission (SEC) and various state securities regulators. As well, companies with SEC-registered securities are regulated by the SEC. OTC Markets Group is neither a stock exchange nor a self-regulatory organization (SRO).
Complaints regarding companies should be directed to the SEC, while complaints regarding broker-dealers or other investment professionals should be directed to FINRA. More information about specific OTC regulations is covered in Part 3 – Regulation.
Inter-dealer Quotation/Trading Systems – Inter-dealer Quotation/Trading Systems allow broker-dealers to post and disseminate their ‘quotes’ (prices) to the market place and, in the case of OTC Link, negotiate trades at agreed-upon prices. The two major Inter-dealer Quotation Systems are:
- OTC Link (operated by OTC Markets Group)
- FINRA OTCBB
OTC Link allows broker-dealers to quote any OTC equity security eligible for quoting under SEC Rule 15c2-11. Currently, there are over 10,000 securities quoted on the OTC Link system. Broker-dealers access the OTC Link system either through OTC Markets Group’ OTC Dealer or OTC FIX applications. These applications allow broker-dealers to view all quotes for OTC securities and, if desired, trade those securities through OTC Link (which is accessible through OTC Dealer and OTC FIX ).
The FINRA OTCBB system, on the other hand, is a quotation only system, as it lacks the electronic messaging capabilities of OTC Link. Furthermore, only companies that are SEC-reporting (or bank/insurance reporting) are eligible for quotation on the FINRA OTCBB. Since these securities may also be quoted on OTC Link, many BB eligible securities are ‘Dually-Quoted’ on both inter-dealer quotation systems. Currently, 99% of OTCBB eligible securities are quoted on OTC Link..
The significant majority of broker-dealers quote the securities of SEC-reporting companies on OTC Link because the FINRA OTCBB does not have electronic trading capability. Broker-dealers must use OTC Markets Group’s OTC Link's trade messaging system to trade these securities electronically.
OTC Markets Group and the FINRA OTCBB distribute their market data to broker-dealers, investment professionals, market data re-distributors, and financial websites, including OTCMarkets.com.
The real-time dissemination of quote information provides price transparency, which leads to a more efficient investment/trading process. The dissemination of price information and company financial data to the investment community (including individuals) leads to the development of new prices via trading decisions. This continuous flow of information between participants defines the OTC market and all market places.
Make sense? You are now ready for Part 2 – Trading.