OTC stock market: features, tools, risks

The over-the-counter (OTC) stock market is an important segment of the stock market, which is both an alternative to the stock market and its addition, explains Vitaly Kirpichev, Development Director of TradingView in Russia.

It is an alternative because for those who are planning a major share deal and do not want to affect stock prices with it, the best way is to find counterparties off the exchange, which can be helped by professional market participants – brokers. Information about such a transaction will be published after its conclusion and will not affect the agreed conditions. If you buy a large block of shares on the exchange, the “domino effect” is quite real, when each purchase will accelerate the value of the company by other traders, worsening the price for the buyer.

This market is complementary because some companies cannot go through the complicated and costly listing procedure on the stock exchange, so they continue to trade in the over-the-counter segment. Nevertheless, among such companies you can find interesting startups that can become “unicorns” in the future. In the US, such a segment of the market is called Pink Sheets (“pink sheets”) because of the color of the paper on which stock quotes were issued that did not or did not want to get listed on the stock exchange.

Why does the over-the-counter market exist?

In order for the issuer’s shares to be traded on the stock exchange, the company must fulfill a number of requirements, in particular, information disclosure. Yaroslav Kabakov, Director of Strategy at IC FINAM, believes that this is the main reason why the papers of not all companies are traded on the stock exchange.

“Some companies are simply not interested in entering the stock exchange, as their shares are owned by a certain circle of investors who are not going to part with them. The over-the-counter market also attracts with access to instruments that are not available on the organized market. The off-exchange market makes it possible for those who enter into forward and option contracts to establish individual conditions for the timing and place of delivery, for the quantity and quality of goods,” adds Elena Belyaeva, analyst at Freedom Finance.

The expert also talks about financial instruments that exist on the OTC market: in addition to stocks and ETFs, bonds are traded here (it is on the OTC market that the main volumes of transactions for this type of exchange instruments take place), transactions are made on forwards and OTC options. The interbank foreign exchange market is also over-the-counter.

Market features

What are the differences between OTC and the exchange market:

The liquidity of the over-the-counter securities market is lower than that of the stock market.

Individuals do not have the ability to independently negotiate with the counterparty on the terms of the transaction.

Depositories’ rates for keeping securities that are not traded on the organized market are usually higher.

In the OTC market, spreads are always wider – the difference between the best buy and sell prices.

The potential profitability of the OTC market is higher than that of the exchange market.

The over-the-counter market can also be organized and unorganized. The principle of operation of an organized over-the-counter market is similar to the exchange market, but the investor’s security is lower there. The unorganized over-the-counter market is even more risky, it is not regulated by any rules, the participants themselves agree on the terms of transactions, the expert says.

The risks are higher

The main risk is that on the over-the-counter market you can find securities of not only proven and reliable issuers, and the fulfillment of obligations is not controlled by the clearing house, warns Sberbank investment analyst Ivan Ipatiev. To reduce the risk, Elena Belyaeva recommends making a deal through a broker – professional participants always check the counterparties of the deal.

The second risk is related to the low liquidity of assets. For this reason, over-the-counter market instruments are often more suitable for those who have sufficient expertise and are focused on the medium-term or long-term horizon, Mikhail Bespalov, an analyst at KSP Capital Asset Management, warns.

“We need to be prepared for a longer wait for a counter offer,” notes an analyst at Freedom Finance.

Experts warn of a third risk: a company whose securities are bought on the over-the-counter market may go bankrupt. For this reason, you need to conduct a fundamental analysis of the company whose securities you are going to buy, and monitor changes in the credit rating. In general, the OTC market is suitable only for experienced investors with a large deposit, Elena Belyaeva is sure.

How does the Russian OTC market differ from the US market?

The American market has existed for much longer, so the over-the-counter market is more orderly there: the securities traded there are divided into categories depending on the level of risk. The lowest-risk category, OTCQX, trades the most reliable companies that qualify for listing on the NASDAQ. Securities of companies that do not meet the listing conditions are circulated on OTCQB, but the reporting requirements are met there, and bankrupt companies are not allowed in this segment. And OTC Pink is the category with the greatest risks for the investor; all other securities are traded here, including companies that have already been declared bankrupt.

“If we talk about volumes and a set of investment instruments, then at the current stage it would not be entirely correct to compare the over-the-counter market of the Russian Federation with the US market, since the possibilities of choice and liquidity in the United States are much higher than in Russia,” says Mikhail Bespalov.

The problems that exist in the Russian over-the-counter market are mainly due to the fact that, unlike the foreign one, the “young” domestic market is at the formation stage and some regulatory norms have not yet been formulated, adapted or adjusted, agrees Ivan Ipatiev from Sberbank. According to him, the legal framework abroad, in Europe and the United States, is broader and more detailed in terms of OTC regulation. For example, in the US, there is an “exclusion” rule, which has the following condition: banks need to move certain financial derivatives (FFIs) to a separately capitalized branch in order to receive government support, including from the Fed. “Volker’s Rule”, for example, prevents certain regulated financial institutions from engaging in private trading of derivatives and limits the rights of banks to invest in private equity funds. At the same time, banks have the right to sell and buy derivatives as a client-side participant.

The main Russian OTC platforms for trading securities are MOEX Board at the Moscow Exchange and SPIMEX at the St. Petersburg Exchange. The development of this segment of the financial market is taking into account the experience and rules adopted on the OTC sites of developed markets, sums up Elena Belyaeva.

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