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The Risks Of Over The Counter Trading

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The Distinction Between Exchange Trading and Over The Counter Trading

over the counter trading

Over the counter trading differs from exchange trading, which is the format under which most stock trading occurs. Investors and brokers must register with an exchange and only trade with fellow members under that exchange’s auspices. The exchange itself acts as a referee and also mitigates financial risks associated with a fellow member’s default. The exchange essentially guarantees that everyone in the exchange will follow certain procedures while trading. This is known as transparent trading.

There is no oversight provided in over the counter trading. This sort of trading occurs only between two parties: the buyer and the seller. The products traded are usually the same as those traded in the exchanges: stocks, bonds, commodities and derivatives. The biggest difference between the two forms of trading is the higher credit risk taken when trading over the counter. If one or both the parties involved acts dishonestly, there is not any overseeing agency to protect either of them from the behavior of the other.

Components of Over The Counter Trading

Over the counter trading is not completely untethered from any outside agency. There is, for instance, the OTC Bulletin Board, which licenses certain actors in this trading arena. Stocks quoted on this bulletin board are required to follow Securities and Exchange Commission rules in regards to reporting. However, other stocks traded over the counter do not have to report any information. Pink Sheets securities are a category of stocks, which does not follow any specific set of disclosure guidelines.

Obviously, there are significant risks associated with over the counter trading. One class of risks that OTC investors run is known as counter party risk. This is the risk that the first party in a trade will default on the contract agreed upon with the second party. Since over the counter trading occurs outside the framework of an exchange, the second party will suffer a loss with no remediation.

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