OTC market
Halt | February 11, 2021 | 0 Comments

Are OTC Markets Legal? How Do They Differ From Exchanges?

Stock markets haven’t been this exciting since, well – ever. In recent weeks, retail traders have discovered their power by mass-buying cheap equities – punishing institutional short-sellers in the process.

However, the tumult surrounding Gamestop (NYSE: GME) has raised questions around what’s legal (and what’s not) when trading equities. In addition to the issues surrounding the internet promotion of individual stocks, some are questioning the legitimacy of OTC markets.

If you aren’t aware, OTC markets aren’t like the NASDAQ, the S&P, or the NYSE. OTC-trading hubs have no real-world exchange – trading partners complete transactions entirely online. However, many firms on these exchanges have serious issues.

So, what exactly are OTC exchanges? Are they legal? Are they safe? Below, we’ll teach you things you never knew about these mysterious markets.

So… Are OTC Markets Legit?

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Scam watchdogs regularly advise readers against trading on OTC markets. However, that doesn’t mean that OTC trading is illegal. In fact, most prominent OTC brokers hold licenses through FINRA (Financial Industry Regulatory Authority.)

However, these brokers aren’t real-world exchanges. Because of this, many rules that regulators impose on the NYSE don’t apply to OTC markets. As a result, many companies that cannot get on mainstream exchanges can be found here.

But the risks on these platforms are higher – much higher. But that fact alone is not enough to make a trading platform illegal.

Why are OTC Markets a Thing?

Outside financing is the lifeblood of countless startups. Here’s why – at some point, ambitions outstrip one’s ability to self-fund. So, these companies seek out financing from crowdsourcing, angel investors, and venture funds.

However, none of these sources can hold a candle to the fundraising potential of an IPO. According to stats clearinghouse Statista, the median IPO size was 108 million USD in 2019. But there’s a problem – for a company to get listed on a mainstream stock exchange, they must disclose loads of sensitive information. In doing so, they’ll spend hours filling in the paperwork and spend a significant sum on application fees.

What info must IPO applicants disclose? They must demonstrate consistent, predictable revenue. They must have solid financials, including the ability to self-fund the IPO process. And they must prove their management team is competent and has a solid plan to grow in the near-term.

Any snags in this process can delay or doom an IPO. So rather than risk failure, some firms opt to trade over-the-counter. Listing on OTC markets is as easy as filling in a form. This way, these companies can access capital from retail investors quickly and easily.

What’s the Difference Between Traditional and OTC Markets?

How Do OTC Markets Work

As you saw above, listing requirements vary significantly between OTC markets and exchanges like the S&P. But, that’s not the only difference between these two trading platforms.

First of all, unlike traditional stock exchanges, OTC markets have no centralized location. While platforms like the NASDAQ have opened up to internet traders in recent decades, OTC markets pioneered that approach.

The second major difference lies in who the market makers are. On traditional exchanges, firms like Citadel Securities provide the liquidity that keeps markets stable. On OTC markets, a vast network of dealers provides the capital needed to accommodate trades.

The third difference – ease of access. As we already illustrated, the IPO process is a long, hard road on established exchanges. But on OTC markets, companies with less-than-perfect leadership/history/liquidity can get listed. This is great for the company in question but hazardous for traders.

Is it Safe to Trade on OTC Markets?

Safety, like most words, has a relative meaning. Will you get hurt or die if an OTC trade goes bad? Probably not. If your broker’s licenses are up to date, they’ll likely pay out your winners. But we’re not going to sugarcoat it – the risks of trading OTC are significantly higher than on mainstream exchanges.

There are three main reasons for this. One, traders are at a huge information disadvantage. OTC companies don’t have to disclose nearly as much about themselves as stock exchange companies do. Because of this, the likelihood of buying toxic equity goes way up.

Secondly, volumes are much lower on OTC platforms. As a result, the bid-ask spread is often super wide. It’s not uncommon to pay twice the listing price to buy an OTC stock. In this situation, this equity would need to double in value for you to recoup your investment.

Finally, most equities on OTC platforms are penny stocks. Consequently, these venues are rife with pump-and-dump schemes. If you get out early, you can make a decent sum. However, most sell on the way down, so they end up losing money.

Are OTC markets safe? If you trade on a regulated broker, absolutely. But trading OTC comes with significant risks. If index funds are your jam, then OTC trading is downright dangerous. But if you are investing capital that you can afford to lose, then you’ll be fine.

How Do OTC Markets Work?

How Do OTC Markets Work

So you’re ready to take a chance on OTC stocks. But how does trading on these platforms work? Here’s the good news – most online brokerage software, which investors use to buy shares on traditional exchanges, also allow OTC transactions. If you already have a brokerage account, you may able to buy over-the-counter. Otherwise, open an account with a broker that permits OTC trades.

Apart from fee differences and the bigger bid/ask spread, the process is similar to exchange trades. However, we’ll repeat it – OTC stocks are inherently riskier than exchange-traded stocks.

As such, in-depth research is crucial when buying these equities. By keeping on top of financial news from the OTC markets, you’ll stand a better chance of making profitable OTC trades.

OTC Markets Can Be Lucrative, But Beware

The allure of quick, easy money draws investors to OTC stocks. However, many are left with nothing but a story to tell. However, by knowing the risks, practicing proper bankroll management, and doing your due diligence, you can maximize your odds of a good outcome.