What does OTC over-the-counter trading mean? Understanding the OTC stock market and its operating mechanism

When investors are interested in a promising company but cannot find it on mainstream exchanges, where should they trade? The answer is the OTC market. The OTC over-the-counter trading market offers more diverse investment options and more flexible trading arrangements. Although it lacks the regulatory protections of centralized exchanges, with the right strategies, investors can still explore opportunities. So, what exactly is OTC? How does it differ from on-exchange trading? These questions are worth investors’ in-depth understanding.

What Does OTC Mean — The Definition of Over-the-Counter Trading

OTC stands for Over The Counter, which translates to “off-exchange trading” in Chinese. Simply put, investors do not buy or sell on formal centralized markets (such as stock exchanges), but instead trade securities and commodities through dispersed channels like banks, brokerages, phone, or electronic systems. This market is also known as “over-the-counter trading,” “desk trading,” or “OTC market.”

In OTC trading, prices are not generated through a unified market bidding process but are negotiated directly between buyers and sellers. The counterparties are highly diverse, including banks, securities firms, corporations, or individual investors. Companies traded OTC are often smaller or in early startup stages, do not meet exchange listing requirements, or are eligible for listing but choose OTC to avoid excessive disclosure of information.

With the development of the internet and the expansion of international financial markets, the demand for trading convenience has increased, leading to rapid growth in OTC market size, becoming an important trading channel for many investors. However, compared to on-exchange trading, OTC markets have lower price transparency, lack strict trading rules and disclosure requirements, and thus carry higher risks, with both parties facing counterparty credit risk.

Current Status of Taiwan’s OTC Stock Market

Taiwan’s stock market is structured into two layers: the “Stock Exchange” and the “OTC Securities Exchange.” The OTC index (also called the OTC Composite Index) compiled by the OTC Securities Exchange reflects the status of Taiwan’s OTC stock market. Many investors observe the OTC index to gauge the trend of small and medium-sized stocks.

The government established the OTC Securities Exchange to address the obstacles posed by overly strict listing standards on companies’ development. Startups can get listed if they are recommended by more than two brokerage firms, and if their performance improves within six months, they can apply to transfer to the main or emerging market. However, the lower entry threshold also brings risks—some unscrupulous companies may slip in, and certain bad brokers may recommend high-risk stocks to harvest profits. Therefore, investors must carefully select targets in the OTC market and choose reputable brokers.

How OTC Over-the-Counter Trading Works

Taiwan’s OTC market operates similarly to the listed market, but with different company sizes and listing standards. The overall process is as follows:

Step 1: Investors place orders through brokers; the process of buying or selling OTC stocks is exactly the same as for listed stocks.

Step 2: The order is transmitted to the OTC Securities Exchange’s matching system, where an automatic trading system (ATS) pairs orders based on price priority and time priority. The entire process and technical rules are synchronized with the listed market, requiring no additional steps.

OTC Trading Daily Operating Rules:

The call auction occurs every 5 seconds, with price fluctuation limits of ±10% (same as the main market). Settlement follows T+2, identical to listed stocks.

Overall, OTC markets mainly consist of small to medium-sized, growth-oriented companies, with higher volatility but attractive growth potential. Due to better liquidity than the Emerging Stock Board and the same system as the main market, general investors face no high barriers to participation. However, because these companies are smaller, they are more susceptible to news and market sentiment, so investors should be cautious of price fluctuations.

Products Traded in OTC Over-the-Counter Markets

Besides stocks and bonds, OTC trading commonly involves financial derivatives. The characteristics of various products are as follows:

Stocks: The largest investment market in OTC trading. Unlike on-exchange trading, OTC includes not only standardized stocks listed on exchanges but also stocks of small and medium-sized enterprises and startups that do not meet listing requirements or have not applied for listing.

Bonds: OTC is more suitable for bond trading due to the large issuance volume, variety, and infrequent trading.

Derivatives: Options, futures, spread contracts, and other derivatives are also traded OTC.

Foreign Exchange: Currency trading on various platforms falls under OTC.

Cryptocurrencies: Popular cryptocurrencies can be traded OTC, allowing investors to purchase large amounts at once, which is difficult on dedicated crypto exchanges.

On-Exchange Trading vs. OTC Trading — Seven Key Differences

To truly understand OTC over-the-counter trading, it’s essential to compare it with on-exchange trading. The main differences are listed below:

Product Specification Differences

On-exchange products are standardized, while OTC products are non-standardized. For example, gold trading—on the exchange is like going to a bank—each unit is uniform; OTC is like going to a pawnshop—each item varies. Pawnshops can trade a wider variety of goods, offering irreplaceable value compared to banks.

Differences in Trading Modes

On-exchange is auction-based, OTC is negotiated. On-exchange trading is transparent and relatively fair, but profit margins are limited. OTC trading lacks transparency; buyers and sellers negotiate prices directly. Since there’s no obligation to disclose, even if someone offers a higher price, the trade may not happen, making information advantage more critical than capital.

Diversity of Main Products

On-exchange mainly involves securities and futures, while OTC includes foreign exchange, cryptocurrencies, and unlisted stocks. Because on-exchange products require standardization and only products with sufficient market scale are listed, the variety is limited. Conversely, OTC products are highly diverse.

Platform and Regulatory Differences

On-exchange markets are approved and regulated by the government, whereas OTC markets are operated by brokers and only partially regulated. OTC trading does not need to occur on government-approved exchanges, which introduces risks of fraud, such as fake exchanges. Investors should choose exchanges with government approval and regulation to ensure safety.

Transparency Gap

On-exchange markets publicly disclose prices and volumes, but OTC markets do not necessarily do so. Since OTC is not mandated to disclose details, information gaps are larger. Experienced traders can exploit this for excess returns, while inexperienced traders may suffer losses.

Trading Volume and Liquidity

On-exchange centralized trading has large volume and high liquidity, while OTC has smaller volume and lower liquidity. Due to effective regulation, on-exchange markets attract international capital, resulting in higher trading volume.

Flexibility in Trading Methods

On-exchange markets have limited trading methods, while OTC offers more options. On-exchange trading involves strict risk controls, with restrictions on leverage and short selling. OTC trading is more flexible, allowing for more diverse investment strategies.

Advantages of OTC Over-the-Counter Trading

✔️ More Investment Options. OTC markets enable access to derivatives, binary options, spread contracts, foreign exchange, and more, providing a broad range of markets.

✔️ More Flexible Trading. Diverse trading methods and product specifications allow for customized investment strategies.

✔️ High Leverage Options. Traditional markets have leverage restrictions, but OTC offers various choices, enabling investors to amplify gains with higher leverage.

✔️ Gradually Improving Security. Modern OTC markets adopt multi-layered security mechanisms similar to centralized markets. Some brokers authorized and regulated by reputable financial institutions are more professional, allowing knowledgeable investors to trade with confidence.

Risks of OTC Over-the-Counter Trading

❌ Lack of Regulatory Protections. OTC markets lack unified rules and transparency, with looser laws and regulations, leading to risks of fraud by unscrupulous brokers. Listed companies and securities must comply with regulations, but many non-compliant companies and securities only trade OTC.

❌ Low Liquidity. OTC securities have lower liquidity than centralized exchanges, which may lead to difficulty obtaining favorable prices.

❌ Market Volatility Risks. OTC trading is affected by market fluctuations, and most investors cannot access the transparent information available on centralized exchanges.

❌ Counterparty Credit Risk. Direct trading between buyers and sellers often lacks regulatory intervention. Some products are highly volatile with low liquidity, and malicious actors may use false information to deceive investors.

Is OTC Over-the-Counter Trading Safe?

Does the absence of exchange regulation mean OTC is unsafe? Not necessarily. Compared to centralized exchanges, OTC trading indeed carries risks. Without a unified market and rules, sellers may offer different prices to different buyers, exposing traders to counterparty credit risk, low liquidity, and potential scams by fraudsters using false information.

However, ordinary investors can take the following measures to ensure OTC trading safety:

First, ensure the broker is secure. Brokers should be regulated at different levels and have strong risk management capabilities.

Second, choose mature trading products. For example, in forex trading, understand spreads, liquidity, and other information for comprehensive assessment.

Third, utilize platform protection measures. Legitimate trading platforms offer investor protections such as risk assessments, KYC identity verification, complaint mechanisms, etc., which help reduce trading risks.

By understanding the true meaning and characteristics of OTC over-the-counter trading, and making careful choices with proper risk management, investors can trade more confidently in the OTC market.