What does OTC mean? | How does over-the-counter trading work, and how is it different from on-exchange trading?

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

Investors seeking stocks of small companies with potential often cannot find them on mainstream exchanges, which is when they turn to the over-the-counter market.

OTC stands for Over The Counter, referring to over-the-counter trading, which means investors do not trade through centralized markets (such as stock exchanges), but rather via decentralized channels, including banks, brokerages, phone, or electronic systems for direct securities transactions. This type of market is also called “pink sheets,” “over-the-counter trading,” or “OTC market.”

The key feature of over-the-counter trading is that prices are not determined through a unified market auction but are negotiated directly between the two trading parties. The counterparties are diverse and may include banks, securities firms, corporations, or individual investors.

Companies that can participate in OTC trading usually do not meet the listing requirements of stock exchanges, often being small to medium-sized or startups. Some companies that do meet listing criteria may choose OTC trading voluntarily to avoid the competitive pressure of extensive disclosures. With the development of the internet and the expansion of international financial markets, investor demand for trading convenience has led to rapid growth in the OTC market.

However, compared to on-exchange trading, OTC prices are less transparent, and the market lacks strict trading rules, information disclosure, and regulatory oversight. As a result, counterparties face higher credit risk.

How OTC Over-the-Counter Trading Works

Taking Taiwan as an example, the overall process of OTC trading is as follows:

Step 1: Investors place orders through a broker The process for buying and selling OTC stocks is identical to that of listed stocks, requiring no special procedures.

Step 2: Orders enter the matching system Brokers upload orders to the OTC’s automatic matching system (ATS), which pairs trades based on the principles of “price priority, time priority.” The trading rules are synchronized with those of the listed market.

OTC Trading Hours and Rules:

• Pre-market trading: 08:30–09:00
• Normal trading: 09:00–13:30
• After-hours pricing: 13:40–14:30
• Call auction: every 5 seconds
• Price fluctuation limit: ±10% (same as listed)
• Settlement system: T+2 (settled within two business days after the trade)

The OTC market mainly features small to medium-sized, growth-oriented companies, with higher volatility but attractive themes and growth potential. Since liquidity is better than the Emerging Stock Board and the system is the same as listed markets, the entry barrier is relatively low. However, due to smaller company size and susceptibility to news and market sentiment, investors should be cautious of price fluctuation risks.

Types of OTC Products

The OTC market offers a much broader range of products than on-exchange trading:

Stocks The largest OTC product category, including not only those listed on exchanges but also small companies and startups that do not meet listing requirements or have not applied for listing.

Bonds More suitable for bond trading, as bonds are issued in large quantities and many varieties, but trading is infrequent.

Derivatives Options, futures, and spread contracts can all be traded OTC.

Foreign Exchange Currency trading on various platforms falls under OTC.

Cryptocurrencies Popular digital assets can be traded OTC, allowing large-volume purchases that are difficult to achieve in specialized markets.

On-Exchange Trading vs. OTC Trading: Seven Major Differences

Differences in Product Standardization

On-exchange trading involves standardized products, while OTC trading involves non-standardized products. For example, gold trading on an exchange like a bank has uniform standards, whereas OTC gold trading resembles pawnshops with varied terms, but offers a wider variety of products with irreplaceable features.

Differences in Trading Mode

On-exchange trading uses call auctions, which are transparent and relatively fair but offer smaller profit margins. OTC trading involves negotiation without public restrictions, where buyers and sellers agree directly. Due to less transparency, information is more important than capital.

Differences in Main Products

On-exchange trading mainly involves securities and futures, while OTC focuses on forex CFDs, cryptocurrencies, and unlisted stocks. Exchange-traded products require standardization and a certain market scale, with fewer product types; OTC products are highly diverse.

Trading Platforms and Regulation

Exchanges are government-approved and regulated by the respective country. OTC markets are broker networks, only partially regulated. OTC trading can occur on non-government-approved platforms, which may be exploited by fraudsters setting up fake exchanges. Investors should choose platforms that are government-approved and regulated.

Price Transparency

Exchanges publish prices and trading volumes openly, whereas OTC markets may not. Since OTC markets lack mandatory disclosure of trading details, information gaps are significant. Experienced traders can earn excess returns, while inexperienced ones may suffer excess losses.

Trading Volume and Liquidity

On-exchange trading has high volume and liquidity, attracting international capital due to proper regulation. OTC trading has lower volume and liquidity.

Trading Flexibility

On-exchange trading offers fewer methods and stricter risk controls, with more restrictions on leverage and short selling. OTC trading is less restricted, allowing more flexible investment strategies.

Introduction to Taiwan’s OTC Market

Taiwan’s stock market is divided into the “Stock Exchange” and the “OTC Market.” The OTC index (also called the OTC Composite Index) reflects the state of Taiwan’s OTC stock market, and many investors observe this index to gauge the trend of small and medium-sized stocks.

The purpose of having two markets is to ensure that listed companies reach a certain scale, but overly strict regulations can hinder development. Many startups have the capability to develop groundbreaking products but lack funding to start.

To address this, the government established the OTC Center, relaxing the criteria. Companies only need recommendations from more than two qualified brokers to list. If within six months the company shows strong performance (profitability improves or financial health enhances), it can apply to transfer to the main or OTC markets.

Because the application criteria are relatively lenient, the OTC market contains both truly high-quality companies and speculative players. Some unscrupulous brokers promote high-risk stocks and manipulate prices to profit from retail investors. Therefore, investors should not only select good targets but also find reputable brokers.

Advantages of OTC Over-the-Counter Trading

Broader Investment Options The OTC market provides access to derivatives, binary options, CFDs, forex trading, and more, offering a wide range of markets.

More Flexible Trading Trading methods and product specifications are more adaptable, allowing customized trading plans based on investment goals.

High Leverage Flexibility Traditional markets have leverage restrictions, but OTC offers various leverage options, enabling higher leverage to amplify gains.

Optimized Regulation and Security Modern OTC markets implement multiple layers of security measures similar to centralized markets. Many brokers operate under licenses from reputable financial institutions, making them more professional. Investors with sufficient knowledge can participate in OTC trading with confidence.

Risks of OTC Over-the-Counter Trading

Lack of Regulation OTC markets lack unified rules and transparency, with looser legal oversight, making fraud by unscrupulous brokers easier. Companies listed on exchanges and securities must comply with strict regulations, whereas many non-compliant companies can only trade OTC.

Insufficient Liquidity OTC securities are less liquid than those on centralized exchanges, which may result in unfavorable prices when trading.

Market Volatility Risks OTC trading is affected by market fluctuations, and most investors do not have access to the transparent information provided by on-exchange trading.

Credit Risks and Scams Since buyers and sellers trade directly, sellers may offer different prices to different buyers. The market may also see malicious actors using false information to deceive investors.

Is OTC Trading Safe? How to Reduce Risks

While OTC trading involves risks, it is not inherently unsafe. To ensure trading safety, investors should take the following measures:

Choose Reputable Brokers Select brokers that are regulated at multiple levels and have strong risk management systems.

Opt for Mature Trading Products For example, in forex, understand spreads, liquidity, and other factors, and consider withdrawal procedures comprehensively.

Use Protective Mechanisms Legitimate trading platforms offer investor protections such as risk assessments, KYC procedures, complaint mechanisms, etc., which help reduce risks.

Conclusion

OTC over-the-counter trading offers broader investment opportunities and greater flexibility compared to traditional exchanges, making it suitable for investors seeking diverse investment forms. However, the looser regulation and lack of transparency also introduce risks. Investors need sufficient market knowledge, risk awareness, and careful platform selection to effectively capitalize on OTC markets. Whether choosing on-exchange or OTC trading, understanding the meaning of OTC and its operational mechanisms is fundamental to making wise investment decisions.