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Trading in securities takes place for the most part on the stock exchanges. However, it is also possible to buy and sell securities and other underlying assets without the intermediate stock exchange. OTC trading is used for this purpose. If you are not familiar with the most important Forex terms, this article will tell you everything you need to know about this type of trading. How does OTC trading work and what are the differences to the stock exchange? What are the advantages of OTC trading? Are there also disadvantages?
Definition of OTC trading
A wide variety of financial products can be traded both on the stock exchange and over the counter. For over-the-counter trading, the term “OTC trading” has become generally accepted. OTC stands for Over the Counter and means translated “over the counter”.
This refers to direct trading on the capital markets between buyer and seller. In “direct trading” and “over-the-counter trading”, the purchase and sale of securities also takes place as OTC trading. OTC trading is thus a further development of telephone trading in the broader sense.
Differences to the stock exchange
The stock exchanges are monitored and regulated by the responsible financial or stock exchange supervisory authority. Not only the leading exchanges but also smaller stock exchanges are monitored. In Germany, for example, the Federal Financial Supervisory Authority (BaFin) and in the USA the United States Securities and Exchange Commission (SEC) are responsible. In comparison with stock exchange trading, there are some differences in OTC trading:
- is not subject to stock exchange supervision
- fewer restrictions on financial products
- there are lower fees
- higher risk than stock exchange trading
- longer trading hours
OTC trading, on the other hand, as already mentioned, does not take place on the stock exchange and is therefore not subject to any supervisory authority. Although the statutory provisions on securities trading apply, there is no state supervision for OTC trading. This of course affects the transparency of the market and over-the-counter trading thus involves a higher risk than stock exchange trading.
The lack of supervision also has the advantage that more financial products can be offered. Securities that have not been standardised and approved for trading on the stock exchange may be tradable over the counter. Exotic warrants are a good example of this. In addition, all securities available on the stock exchange are also available for OTC trading. In most cases, however, the liquidity on the stock exchange is higher.
On the other hand, the trading hours in OTC trading are longer. Private investors can generally buy and sell securities off-exchange between 8 a.m. and 10 p.m., while the official stock exchange hours in Germany are from 9 a.m. to 5.30 p.m. If you want to learn more about trading hours, take a look at our Forex Wiki, where we explain the most important trading terms.
OTC trading can also score points when it comes to costs. Since trading takes place directly between the seller and buyer, there are no fees for the exchange or third-party fees such as brokerage fees. However, private investors naturally pay fees for the broker who initiates the trade between the market participants. However, these fees are usually lower than the costs of trading on the exchange.
Procedure of OTC trading
As a private investor, you will have access to OTC trading via an online broker. This acts as an interface between buyer and seller or issuer. The trading process is as follows:
The buyer submits a price request to the online broker.
If he agrees with the price, he places an order with the online broker.
The order is forwarded to a market participant.
When the seller or issuer has accepted the order, it is executed.
This process only takes a few seconds to minutes.
So the first thing the buyer is interested in is a financial product. It does not matter whether he wants to take a long or a short position. The price for the specific financial product is called up from the online broker via the Internet. In return, the online broker obtains a non-binding price that another market participant would like to have for this financial product. This market participant can either be an issuer of securities or an ordinary trader, possibly also a private investor.
If the buyer decides to accept the offer, the seller is informed and has the opportunity to refuse. If, in the meantime, the price has changed to the seller’s disadvantage, the seller will of course reject the offer. On the fast-moving financial markets, this can happen in a matter of seconds. However, if the seller accepts, the order is executed.
The prerequisite for participation in OTC trading is an online broker who also supports this type of trading. Not all, but many of the brokers offer this service. Some brokers also offer over-the-counter trading, but without direct access to other market participants. Here you should clarify on a case-by-case basis whether the online broker enables direct trading with other market participants.
Advantages and disadvantages of OTC trading for private investors
For private investors, the fact that fees are no longer charged is probably one of the most important points. OTC trading can be particularly useful for traders who place many buy and sell orders, as is the case with a day trader, for example. Trading in shares, options, foreign exchange and other financial products can be processed quickly and cost-effectively.
Furthermore, it is also possible to trade modified financial products that do not meet the standards of the stock exchange. As a layman, however, you should pay particular attention here, as there is no way to compare the trading prices on the stock exchange!
With financial products that are traded both on the stock exchange and OTC, however, you can easily compare whether the prices offered are in line with the market. Check which way you can obtain the desired security at a lower price and act accordingly!
Outside the official stock exchange hours this proves to be difficult to do. In such cases you should only trade in financial products with which you are very familiar. Overall, however, OTC trading offers some advantages, which is why you can accept the slightly higher risk compared to the stock exchange.