Exchange-traded securities change hands via an exchange platform. Two such platforms that most people are familiar with are the New York Stock Exchange and NASDAQ. The stocks, bonds and other instruments traded on these exchanges are known as listed securities.
Over the counter, or OTC, traded securities encompass all other financial securities. Any time a financial security changes hands between two parties outside of the major exchanges, the trade is referred to as an OTC transaction.
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Understanding the differences between listed and OTC transactions is crucial whether you want to trade shares or sell your firm's shares to investors.
Exchange-traded markets are centralized markets where a single party connects buyers and sellers. Over-the-counter markets are decentralized and many intermediaries connect buyers and sellers.
Regulatory Oversight from Authorities
All companies are subject to certain rules and regulations imposed by state and federal authorities. When a stock is listed in an exchange, however, the regulatory oversight increases dramatically.
For example, the firm must make certain key financial information available to the public free of charge, and employees of the firm are prohibited from trading the firm's stock if they are in possession of material non-public information that could impact the stock's performance.
Shares of companies that fail to follow these and other requirements can be removed from the exchange in a process called "delisting." The share price, as well as the value of the entire firm, must also exceed certain thresholds. It is therefore difficult for a small firm to trade its stock on an exchange.
However, any stock can be traded over the counter.
Counterparty Risks in Transactions
When you buy or sell something OTC in a private transaction, there is always the risk of not getting what you bargained for. The other party might not be able to deliver the stock, bond or other security within the agreed upon time frame. It might also deliver a different kind of stock or bond than promised. These risks are broadly referred to as counterparty risk.
In an exchange, however, counterparty risk is not an issue. The trading occurs through brokers who are closely monitored by both the exchange and the Securities and Exchange Commission. Investors buy exchange-traded securities with greater confidence and therefore pay more for such stocks.
Because of this, businesses are better off selling shares through an exchange rather than in a private transaction.
Standardization in Securities
Stocks usually have only a few varieties, such as common, preferred, Type A and Type B shares. But other financial securities can come in numerous flavors. For example, a stock option – which gives the holder the right but not the obligation to buy or sell a stock, bond or other investment – comes with an expiration date.
Options also have "strike" prices, which is the price the option holder can buy or sell a security at if she so chooses. While exchange-traded options have only a few expiration dates for any given month, and the strike prices go up in specific increments, an OTC option can have any expiration date and strike price the buyer and seller agree upon.
Using an Intermediary
In the OTC market, you can do business directly with the buyer or seller. If a small firm's retiring owner wants to sell his shares, for example, you can buy these shares directly from him. While it is advisable to bring a lawyer to document the transaction, the transaction requires no intermediary.
Transactions in an exchange must go through a broker-dealer. No matter how much money you have, you cannot directly access the buyers and sellers in the New York Stock Exchange or NASDAQ on your own. You must pay commissions to a broker, who will then execute the transaction on your behalf.