OTC versus Exchange Trading
Both traditional exchange and over-the-counter, or OTC, refer to financial marketplaces where buyers and sellers meet to bid and execute transactions on financial assets. But while the traditional market is regulated by strict trading limitations and guidelines around visibility, OTC trade is differentiated by the flexibility it enables through direct, custom exchanges made and managed between two parties.
The ways in which assets are traded determine price, stability, and access within the market, and both OTC and traditional exchange provide unique benefits and risks based on their trading infrastructures.
Here’s what traditional exchange and OTC trade each have to offer.
Traditional Exchange
Format
Trades made through traditional markets like the New York Stock Exchange (NYSE), Nasdaq Stock Market, and London Stock Exchange (LSE) have long been conducted only in centralized physical locations and during designated trading hours, typically between 9:30 a.m. to 4:00 p.m. Eastern Time.
The advent of electronic communication networks, or ECNs, has enabled a greater degree of freedom through the allowance of exchanges completed online and after standard hours, but these networks remain as highly regulated and monitored as floor trading. After-hours exchange is accessible primarily via industry established brokers such as Fidelity, Charles Schwab, and TD Ameritrade.
Execution
The market for traditional exchange acts as the central hub for trade activity. Buyer and seller trade matches are determined through price and time priority algorithms, and exchanges are aggregated through a public order book that provides the public market with confidence through order visibility.
For institutional traders who prefer not to disclose order details in the execution of trades with a large quantity or ask price, trading via dark pools provides a private exchange forum. Dark pools operate in between traditional exchange and OTC. Some traditional exchanges offer dark pool services for institutional investors.
Depending on the asset and type of exchange trades might be completed in person, via hand signal, or digitally. Once a trade has been agreed upon between buyer and seller, the transaction price is communicated with the market at large in order to maintain fair price transparency for all traders.
Regulation
Traditional exchanges operate by a strict set of standards that limit trades as well as allowances for buyers and sellers. Trading access is limited by certain entrant criteria around income, stock, shareholders counts and more, as well as daily trade and withdrawal caps for approve traders. Even as some trade communications go digital, stringent standards remain in place for all traditional exchanges.
Risk
While the many rules and public nature of traditional exchanges are intended to help traders avoid risk, the market does offer its own set of hazards. Market fluctuations mean that traders might see individual stocks drop in value after trade, and also face the potential for unpredictable market decline.
Traditional exchange that trades in cryptocurrency is known as centralized exchange, and operates by taking custody of client assets. For cryptocurrency traders, this exchange method is highly vulnerable to hacking and market slippage as the outdated format lacks the necessary protections and liquidity for digital finance. Mt. Gox, one of the largest bitcoin exchanges, lost over $500 million USD in Bitcoin and cash through a breach that resulted from its centralized exchange model.
OTC
Format
OTC describes the informal trading system that once served as the sole financial marketplace option. With the standardization of traditional exchange, OTC now caters to buyers and sellers with more agile trading needs through a decentralized network of dealers who communicate bids, negotiate prices, and facilitate one-on-one trades electronically.
Many desirable, non-standardized financial instruments are only available to OTC market traders, including interest rate swaps, asset backed securities (ABS), forwards, and access to the global foreign exchange market.
Execution
Dealers can make exchanges from their own assets via principal trading, or broker private, bilateral trades between clients. The OTC market is primarily driven by dealer insights on asset value, which they share among an interdealer network as well as with outside clients looking to trade. The OTC single price per buy order system can provide more competitive pricing, and its high liquidity is better suited to cryptocurrency trade than standard market infrastructure.
Unlike in traditional exchange, the details of OTC trades such as price and execution are not typically made available to other market participants. Choosing to trade through the one-on-one OTC model is especially beneficial when trading a large order, as revealing a large quantity and price details over a traditional exchange’s public order book will lead to market slippage.
Regulation
A decentralized, flexible OTC market offers a unique trading opportunity for businesses and individuals that don’t meet the traditional exchange listing guidelines. Trades are based solely upon agreements made between two parties or executed by a dealer, enabling tailored exchanges and smaller deals impossible in a traditional market.
An OTC market can remain structured as long as there is a discovery gap between supply and demand. It is relatively simple to create an OTC market compared to a traditional exchange due its lack of regulatory and compliance requirements. Companies trading OTC can be found listed on pink sheets, a list of active traders and bid prices for OTC stocks published daily.
Risk
While its freedoms make OTC a favorable market for many traders, a lack of regulation and transparency do come with some risk. Counterparties in OTC trade are dealers and clients, and risk can stem from either party failing to deliver on an agreed upon trade.
The amount of asymmetric information in OTC trade is also extremely high due to the lack of transparency that benefits traders in the flexible market. Because exchanges are private, OTC brokers and dealers have the ability to manipulate asset prices and profit against retail investors unfamiliar with market conditions.
OTC exchange has also become fragmented through a market that favors and incentivizes large, legacy brokers with far lower acquisition costs than those designated to newer OTC brokers with less credibility. In some extreme situations like thinly traded assets, large OTC brokers can monetize their credibility by unfairly dictating market prices and trading terms.
Whether it’s trading in a traditional exchange or through an OTC broker, both avenues offer unique benefits and challenges. An integral measure of an efficient and scalable financial system is the ability for market participants to differentiate asset quality through a diverse selection of financial instruments. Besides serving the function of a marketplace for buyers and sellers, traditional exchanges and OTC markets are vital for providing diversity to the financial system.
Building with NUTS Finance
To keep participants protected and accountable in the open financial market, NUTS provides a collection of open source technology modules that secures non-standardized trading and provides the transparency needed to safeguard every transaction.
NUTS Finance is building an open technology framework to support the issuance of diversified financial instruments on the blockchain. Our vision is to enable an open, inclusive and transparent financial system by simplifying the issuance process of financial instruments; reducing the barriers to entry in financial services markets for all participants.
