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Over-the-counter (OTC) or off-exchange trading is done directly between two parties, without the supervision of an
exchange Exchange may refer to: Places United States * Exchange, Indiana Exchange is an Unincorporated area, unincorporated community in Green Township, Morgan County, Indiana, Green Township, Morgan County, Indiana, Morgan County, in the U.S. state of In ...
. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating
liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity In business Business is the activity of making one's living or making money by producing or buying and selling ...

liquidity
, providing transparency, and maintaining the current
market price A price is the (usually not negative) quantity Quantity is a property that can exist as a multitude or magnitude, which illustrate discontinuity and continuity. Quantities can be compared in terms of "more", "less", or "equal", or b ...
. In an OTC trade, the price is not necessarily publicly disclosed. OTC trading, as well as exchange trading, occurs with
commodities In economics, a commodity is an economic goods, good, usually a resource, that has full or substantial fungibility: that is, the Market (economics), market treats instances of the good as equivalent or nearly so with no regard to who Production ...
,
financial instrument Financial instruments are monetary contracts A contract is a legally binding document between at least two parties that defines and governs the rights and duties of the parties to an agreement. A contract is legally enforceable because it me ...
s (including
stock In finance, stock (also capital stock) consists of all of the shares In financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities i ...

stock
s), and
derivatives Derivative may refer to: In mathematics and economics *Brzozowski derivative in the theory of formal languages *Derivative in calculus, a quantity indicating how a function changes when the values of its inputs change. *Formal derivative, an opera ...
of such products. Products traded on the exchange must be well standardized. This means that exchanged deliverables match a narrow range of quantity, quality, and identity which is defined by the exchange and identical to all transactions of that product. This is necessary for there to be transparency in trading. The OTC market does not have this limitation. They may agree on an unusual quantity, for example. In OTC, market contracts are bilateral (i.e. the contract is only between two parties), and each party could have credit risk concerns with respect to the other party. The OTC derivative market is significant in some asset classes:
interest rate An interest rate is the amount of interest In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investm ...
,
foreign exchange The foreign exchange market (Forex, FX, or currency market) is a global decentralization, decentralized or Over-the-counter (finance), over-the-counter (OTC) market for the trading of currency, currencies. This market determines Exchange rate ...
,
stock In finance, stock (also capital stock) consists of all of the shares In financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities i ...

stock
s, and
commodities In economics, a commodity is an economic goods, good, usually a resource, that has full or substantial fungibility: that is, the Market (economics), market treats instances of the good as equivalent or nearly so with no regard to who Production ...
. In 2008 approximately 16 percent of all U.S. stock trades were "off-exchange trading"; by April 2014 that number increased to about 40 percent. Although the notional amount outstanding of OTC derivatives in late 2012 had declined 3.3% over the previous year, the volume of cleared transactions at the end of 2012 totalled US$346.4
trillion A trillion is a number with two distinct definitions: * 1,000,000,000,000, i.e. one million million, or (ten to the twelfth power Power typically refers to: * Power (physics) In physics, power is the amount of energy transferred or converted ...
. "The
Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution An international financial institution (IFI) is a financial institution that has been established (or chartered) by more than one country, and hence is subject ...

Bank for International Settlements
statistics on OTC derivatives markets showed that notional amounts outstanding totalled $693 trillion at the end of June 2013... The gross market value of OTC derivatives – that is, the cost of replacing all outstanding contracts at current market prices – declined between end-2012 and end-June 2013, from $25 trillion to $20 trillion."


Stocks

In the United States, over-the-counter trading in stock is carried out by
market maker A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the ''bid–ask spread'', or ''turn.'' The function of a market maker is t ...
s using inter-dealer quotation services such as OTC Link (a service offered by
OTC Markets Group OTC Markets Group (previously known as Pink Sheets) is an American financial market providing price and liquidity information for almost 10,000 over-the-counter (OTC) securities. The group has its headquarters in New York City New York ...
) and the
OTC Bulletin BoardThe OTC (Over-The-Counter) Bulletin Board or OTCBB is a United States Financial quote, quotation medium operated by the Financial Industry Regulatory Authority (FINRA) for its subscribing members. The board was used for many over-the-counter (finan ...
(OTCBB, operated by
FINRA The Financial Industry Regulatory Authority (FINRA) is a private American corporation that acts as a self-regulatory organization A self-regulatory organization (SRO) is an organization that exercises some degree of regulatory authority over an ...
). The OTCBB licenses the services of OTC Link for their OTCBB securities. Although exchange-listed stocks can be traded OTC on the
third marketThird market in finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have mone ...
, it is rarely the case. Usually OTC stocks are not listed nor traded on exchanges, and vice versa. Stocks quoted on the OTCBB must comply with certain limited
U.S. Securities and Exchange Commission The U.S. Securities and Exchange Commission (SEC) is a large independent agency of the United States federal government, created in the aftermath of the Wall Street Crash of 1929 The Wall Street Crash of 1929, also known as the Great Crash ...
(SEC) reporting requirements. The SEC imposes more stringent financial and reporting requirements on other OTC stocks, specifically the
OTCQX OTC Markets Group (previously known as Pink Sheets) is an American financial market providing price and liquidityLiquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity, t ...
stocks (traded through the OTC Market Group Inc). Other OTC stocks have no reporting requirements, for example Pink Sheets securities and "gray market" stocks. Some companies, with Wal-Mart as one of the largest, began trading as OTC stocks and eventually upgraded to a listing on fully regulated market. By 1969 Wal-Mart Stores Inc. was incorporated. In 1972, with stores in five states, including Arkansas, Kansas, Louisiana, Oklahoma and Missouri, Wal-Mart began trading as over-the-counter (OTC) stocks. By 1972 Walmart had earned over US$1 billion in sales — the fastest company to ever accomplish this. In 1972 Wal-Mart was listed on the New York Stock Exchange (NYSE) under the ticker symbol WMT. In ''
Kiplinger Kiplinger ( ) is an American publisher of business forecasts and personal finance advice which is a subsidiary of Dennis Publishing. Kiplinger Washington Editors, Inc., was a closely held company managed for more than nine decades by three gener ...
'' in 2017, Dan Burrows wrote that American OTC markets are rife with
penny stock #REDIRECT Penny stock Penny stocks are common shares of small public companies that trade for less than five dollars per share. The U.S. Securities and Exchange Commission (SEC) uses the term "Penny stock" to refer to a security Security is fre ...
fraud and other risks, and should generally be avoided by investors "with the exception of large, established foreign firms". Reputable companies located outside the U.S., he notes, sometimes sell stock over-the-counter to gain access to American markets while avoiding the expense of keeping two sets of audited paperwork to be listed on multiple stock exchanges (one in their homeland or to international standards, and one for American standards).


Contracts

An over-the-counter is a
bilateral Bilateral may refer to any concept including two sides, in particular: *Bilateria, bilateral animals *Bilateralism, the political and cultural relations between two states *Bilateral, occurring on both sides of an organism (Anatomical terms of loc ...
contract in which two parties (or their brokers or bankers as intermediaries) agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. Forwards and swaps are prime examples of such contracts. It is mostly done online or by telephone. For
derivatives Derivative may refer to: In mathematics and economics *Brzozowski derivative in the theory of formal languages *Derivative in calculus, a quantity indicating how a function changes when the values of its inputs change. *Formal derivative, an opera ...
, these agreements are usually governed by an
International Swaps and Derivatives Association The International Swaps and Derivatives Association (ISDA ) is a trade organization of participants in the market for over-the-counter derivatives. Headquartered in New York City New York, often called New York City to distinguish it from ...
agreement. This segment of the OTC market is occasionally referred to as the "
Fourth MarketFourth market trading is direct institution-to-institution trading without using the service of broker-dealers, thus avoiding both commissions, and the bid–ask spread The bid–ask spread (also bid–offer or bid/ask and buy/sell in the case of a ...
". Critics have labelled the OTC market as the "dark market" because prices are often unpublished and unregulated. Over-the-counter derivatives are especially important for hedging risk in that they can be used to create a "perfect hedge". With exchange traded contracts, standardization does not allow for as much flexibility to hedge risk because the contract is a one-size-fits-all instrument. With OTC derivatives, though, a firm can tailor the contract specifications to best suit its risk exposure.


Counterparty risk

OTC derivatives can lead to significant risks. Especially
counterparty risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest Interest, in finance and economics, is p ...
has gained particular emphasis due to the credit crisis in 2007. Counterparty risk is the risk that a counterparty in a derivatives transaction will
default Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance) In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It ...
prior to expiration of the trade and will not make the current and future payments required by the contract. There are many ways to limit counterparty risk. One of them focuses on controlling credit exposure with
diversification Diversification may refer to: Biology and agriculture * Genetic divergence, emergence of subpopulations that have accumulated independent genetic changes * Agricultural diversification involves the re-allocation of some of a farm's resources to ne ...
,
netting In law Law is a system A system is a group of Interaction, interacting or interrelated elements that act according to a set of rules to form a unified whole. A system, surrounded and influenced by its environment, is described by its ...

netting
, collateralisation and hedging.
Central counterparty clearingA central clearing counterparty (CCP), also referred to as a central counterparty, is a financial institution Financial institutions, otherwise known as banking institutions, are corporation A corporation is an organization—usually a grou ...
of OTC trades has become more common in recent years, with regulators placing pressure on the OTC markets to clear and display trades openly.A Focus on OTC Clearing Innovation
.
Intercontinental Exchange The Intercontinental Exchange (ICE) is an American Fortune 500 company formed in 2000 that operates global exchanges, clearing houses and provides mortgage technology, data and listing services. The company owns exchanges for financial Fin ...
. In their market review published in 2010 the
International Swaps and Derivatives Association The International Swaps and Derivatives Association (ISDA ) is a trade organization of participants in the market for over-the-counter derivatives. Headquartered in New York City New York, often called New York City to distinguish it from ...
ISDA 2012 Market Analysis drew on "information sources including LCH.Clearnet’s SwapClear, TriOptima, the DTCC Trade Information Warehouse,
Markit Markit Ltd. was a British financial information and services company with over 4,000 employees, founded in 2003 as an independent source of credit derivative pricing. The company provides independent data Data (; ) are individual facts, st ...
,
ICE Ice is water Water (chemical formula H2O) is an , transparent, tasteless, odorless, and , which is the main constituent of 's and the s of all known living organisms (in which it acts as a ). It is vital for all known forms of , eve ...
, , ISDA’s 2012 Margin Survey and other clearinghouses and trade vendors."
examined OTC Derivative Bilateral Collateralization Practice as one way of mitigating risk.


Importance of OTC derivatives in modern banking

OTC derivatives are significant part of the world of global finance. The OTC derivatives markets grew exponentially from 1980 through 2000. This expansion has been driven by interest rate products, foreign exchange instruments and credit default swaps. The notional outstanding of OTC derivatives markets rose throughout the period and totalled approximately US$601 trillion at December 31, 2010. In their 2000 paper by Schinasi et al. published by the
International Monetary Fund The International Monetary Fund (IMF) is an international financial institution, headquartered in Washington, D.C. ) , image_skyline = , image_caption = Clockwise from top left: the Washington Monument The ...

International Monetary Fund
in 2001, the authors observed that the increase in OTC derivatives transactions would have been impossible "without the dramatic advances in information and computer technologies" that occurred from 1980 to 2000. During that time, major internationally active financial institutions significantly increased the share of their earnings from derivatives activities. These institutions manage portfolios of derivatives involving tens of thousands of positions and aggregate global turnover over $1 trillion. At that time prior to the financial crisis of 2008, the OTC market was an informal network of bilateral counter-party relationships and dynamic, time-varying credit exposures whose size and distribution tied to important asset markets. International financial institutions increasingly nurtured the ability to profit from OTC derivatives activities and financial markets participants benefitted from them. In 2000 the authors acknowledged that the growth in OTC transactions "in many ways made possible, the modernization of commercial and investment banking and the globalization of finance". However, in September, an IMF team led by Mathieson and Schinasi cautioned that "episodes of turbulence" in the late 1990s "revealed the risks posed to market stability originated in features of OTC derivatives instruments and markets. The
NYMEX The New York Mercantile Exchange (NYMEX) is a commodity In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, al ...
has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.


See also

*
Collateral managementCollateral has been used for hundreds of years to provide security against the possibility of payment default by the opposing party in a trade. Collateral management began in the 1980s, with Bankers Trust and Salomon Brothers taking Collateral (fina ...
*
Dark liquidity ''Dark Pool'' is the third studio album by Black Rain (band), Black Rain, released on August 12, 2014 by Blackest Ever Black. Reception In their review of ''Dark Pool'', Fact (UK magazine), Fact said "in an age where much dance music is set on e ...
* Delta One *
London Platinum and Palladium Market The London Platinum and Palladium Market (LPPM) is an over-the-counter Over-the-counter (OTC) drugs are medicine Medicine is the Art (skill), art, science, and Praxis (process) , practice of caring for a patient and managing the diagnosis, ...


Notes


Citations


References

* * * * * * * * *


External links


European Union proposals on derivatives regulation - 2008 onwards

Understanding Derivatives: Markets and Infrastructure – Chapter 3, Over-the-Counter Derivatives
By Richard Heckinger, Ivana Ruffini, and Kirstin Wells (Federal Reserve Bank of Chicago) {{Authority control Financial risk Stock market Derivatives (finance) Financial markets Electronic trading systems Mathematical finance