Understanding the OTC Market: A Complete Guide from Definition to Investment Strategies

When investors discover promising companies that cannot be found on major exchanges, the OTC market becomes an important alternative. The OTC (Over The Counter) market offers a wider range of investment products, customizable trading methods, and more flexible trading sizes, but also comes with higher risks and challenges. This article will thoroughly explain how the OTC market operates, compare its advantages and disadvantages, and highlight key points for safe trading.

What is the OTC Market? The Core Concept of Over-the-Counter Trading

The OTC market, short for “Over The Counter,” refers to trading that occurs outside centralized markets (such as stock exchanges). Investors buy and sell securities or other products through dispersed channels like banks, brokerages, phone, and electronic systems. The OTC market is also known as “over-the-counter trading,” “desk trading,” or “pink sheets.”

Unlike centralized exchanges, OTC prices are not determined through a unified bidding process but are negotiated directly between trading parties. Counterparties are diverse and can include banks, securities firms, corporations, or individual investors.

Typically, companies traded OTC are small to medium-sized or startup firms that do not qualify for exchange listing. However, some companies that meet listing criteria may choose OTC trading to avoid the competitive pressure of extensive disclosure requirements.

Because OTC markets are less regulated, traders can operate under more flexible rules, offering a broader variety of products. With the development of the internet and the expansion of international financial markets, OTC trading has grown rapidly and has become a favored method among global investors. However, due to lower price transparency, lack of strict trading rules, and regulation, OTC markets carry higher risks, including counterparty credit risk and information asymmetry.

How the OTC Market Works: Detailed Trading Process

Taking Taiwan as an example, the OTC market operates similarly to the listed market, with main differences in company size and listing standards.

Trading process includes the following steps:

1. Investor places an order through a broker. Buying or selling OTC stocks is performed in the same way as on the stock exchange.

2. Order is sent to the OTC clearing system. When an investor submits a buy or sell order, the broker uploads it to the OTC’s automated trading system (ATS). The ATS matches orders based on price priority and time priority, executing trades with counterparties in the market. The overall process and technical rules are synchronized with the exchange market, requiring no special operations or additional features.

OTC Market Trading Hours and Rules:

Trading rules include:

• Price aggregation every 5 seconds (same as Taiwan’s listed and OTC markets)
• Price fluctuation limit: ±10% (same as listed)
• Price limit up/down restrictions
• Aggregation bidding mechanism
• Matching trade mechanism
• Daily trading hours

OTC companies must comply with disclosure regulations, including quarterly and annual reports and major news, making their transparency higher than other OTC markets. Settlement for OTC stocks follows T+2, identical to listed stocks, with settlement completed within two working days after trade.

Advantages and Risks of the OTC Market: Investment Considerations

Advantages

✔️ More Investment Options: The OTC market enables access to derivatives, binary options, contracts for difference (CFDs), forex trading, and more, broadening market choices.

✔️ More Flexible Trading: OTC trading methods and product specifications are highly adaptable, allowing for customized transactions aligned with individual investment goals.

✔️ High Leverage Flexibility: Traditional markets offer limited and regulated leverage, whereas OTC markets can provide various leverage options, enabling investors to amplify gains with higher leverage.

✔️ Enhanced Security Measures: Modern OTC markets have gradually optimized security protocols, with multi-layered protections similar to centralized markets. Many licensed financial institutions and regulated brokers offer more professional services.

Risks

❌️ Less Regulation: OTC markets lack unified rules and oversight, resulting in relatively lax legal constraints, which can lead to fraudulent brokers. While listed companies must follow strict regulations, many non-compliant companies and securities only trade OTC.

❌️ Lower Liquidity: OTC securities generally have lower liquidity than centralized exchanges, meaning investors may face difficulties executing trades at desired prices.

❌️ Market Risks: OTC markets are affected by market volatility, and investors lack the transparent, publicly available information typical of exchanges. Some products exhibit large price swings and low liquidity, increasing investment risk.

❌️ Information and Fraud Risks: There is a risk of malicious actors spreading false information to deceive investors, exposing them to credit risk and information gaps.

What Products Can Be Traded on the OTC Market?

Beyond stocks and bonds, OTC markets commonly feature financial derivatives. The main product types include:

• Stocks: The largest OTC investment category, including small companies that do not meet listing criteria or have not applied for listing, especially startups with growth potential.

• Bonds: OTC is more suitable for bond trading due to the large issuance volume and variety, with less frequent trading.

• Derivatives: Options, futures, and contracts for difference (CFDs) are all applicable in OTC trading.

• Forex: Currency trading on various platforms falls under OTC.

• Cryptocurrencies: Popular cryptocurrencies can be traded OTC, allowing investors to purchase large amounts in a single transaction—something difficult to achieve on dedicated crypto exchanges.

Taiwan’s OTC Market Features and Investment Opportunities

Taiwan’s stock market is divided into the “Stock Exchange” and the “OTC (Over-the-Counter) Market,” managed by the Taipei Exchange (TPEx). The OTC market has an index called the “OTC Index” (also known as the TPEx Index), reflecting the state of Taiwan’s OTC stocks. Many investors monitor this index to gauge the trend of small and medium-sized stocks.

The reason for a two-tiered market is to ensure that listed companies meet certain size standards, but overly strict regulations can hinder many startups from developing. Many innovative companies have the potential to launch groundbreaking products but lack sufficient funding to commercialize their ideas.

To address this, the government established the Taipei Exchange, relaxing listing requirements so that companies with at least two supporting broker recommendations can list. If a company shows progress within six months—such as improved profitability or financial health—it can apply to transfer to the main or OTC market.

However, because the entry threshold is lower than for main or OTC listings, the OTC market also attracts some dubious companies. Additionally, some opportunists may use unscrupulous brokers to promote high-risk stocks for profit, similar to the “pink sheet” trading depicted in the movie “The Wolf of Wall Street.” Therefore, investors aiming to profit from OTC trading should carefully select reputable brokers and good-quality stocks.

On-Exchange Trading vs. OTC Trading: The Differentiated Advantages of the OTC Market

The emergence of centralized exchanges primarily aims to standardize “product specifications.” Compared to the strict rules of on-exchange trading, OTC markets are closer to the fundamental economic principle of supply and demand. The main differences are:

Product Standardization: On-exchange trading involves standardized products, while OTC products are non-standardized. Similar to gold trading—on the exchange like a bank (standardized), OTC like a pawnshop (varied conditions). Pawnshops can trade a wider variety of goods, making them irreplaceable in some cases.

Trading Mode: On-exchange uses auction (call auction), OTC relies on negotiation. Exchange trading is transparent and fair but offers less profit margin; OTC trading involves direct negotiation, which can be less transparent but more flexible. In OTC, prices are negotiated, and even if someone offers a higher price, you may not get the trade, emphasizing the importance of information over capital.

Main Products: Exchange mainly trades securities and futures; OTC offers forex CFDs, cryptocurrencies, unlisted stocks, and more. Due to the need for standardization, exchange products are fewer; OTC products are highly diverse.

Platforms and Regulation: Exchanges are government-approved and strictly regulated. OTC platforms are often operated by brokers or online platforms with partial regulation. Some OTC platforms are unregulated, increasing the risk of scams. Investors should choose regulated and licensed platforms for safety.

Transparency: Exchange prices and volumes are public; OTC prices and volumes are not necessarily disclosed. Lack of mandatory transparency can lead to information gaps, allowing savvy traders to profit from arbitrage but risking losses for others.

Liquidity and Trading Volume: Exchanges have high trading volume and liquidity, attracting international capital. OTC markets have lower volume and liquidity, making trading less smooth.

Trading Methods: Exchange trading is more limited; OTC offers more options. Exchange operations are more risk-controlled, with restrictions on leverage and short selling; OTC allows more flexible trading strategies.

Is OTC Trading Safe? How to Choose a Secure Broker

Does the lack of exchange regulation mean OTC trading is unsafe? Not necessarily. Compared to centralized exchanges, OTC markets do carry more risks.

OTC markets lack unified rules and regulation, and operate through bilateral negotiations. Sellers may offer the same stock at different prices to different buyers. This exposes investors to counterparty credit risk and the risk of large price swings and low liquidity in certain products. There is also a risk of fraud, with malicious actors spreading false information to deceive investors.

For ordinary investors, ensuring OTC trading safety primarily depends on choosing a reputable and regulated broker. These brokers should be under various regulatory authorities and have strong risk management measures.

Additionally, selecting mature trading products like forex, and understanding details such as spreads and liquidity, is crucial.

Some legitimate OTC platforms implement investor protections such as risk assessments, KYC procedures, complaint mechanisms, and more, which help reduce trading risks.

Key factors for choosing a safe broker:

• Multiple regulatory licenses (e.g., ASIC, CIMA, FSC)
• Robust risk management tools (e.g., stop-loss, negative balance protection)
• Transparent fee structures and trading conditions
• Complete customer protection and complaint handling
• Educational resources and market analysis tools

Opting for licensed, well-regulated brokers with comprehensive risk controls is essential for safe OTC trading.