What is OTC? Pros and Cons of Over-the-Counter Trading Instruments
Over-the-Counter Trading refers to the digital trade that is made between two parties that is not based on a public exchange order book. This trade is less regulated by securities as it is carried out over the counter. This trade is mostly done when large volumes of transactions are to be carried out. While there are some advantages associated with this type of trade, there are also risks that should be noted as well.
OTC markets remain significant in global finance as it gives access to buying or selling on a large scale, providing confidentiality about the strategies by individuals or organizations and also, flexibility about time, price and everything relating to the deal. All of these are enjoyed by traders and business owners that are prone to using OTC trading for their digital assets. WL Global Solutions can support the exchange and over-the-counter structures, this can guarantee an effective and smooth exchange of digital assets.
Understanding the OTC Market
In practice, OTC trading is used to buy and sell financial assets that will not move the markets. It allows for a negotiation that will be used to move large amounts of money without any specific interference of public exchanges. Secrecy mode is activated in OTC markets, as all the transactions are not opened to the public. OTC trading differs from centralized exchange trading by a number of factors which include CEX does not allow for negotiation (but OTC does), CEX trades are usually open to the public and guided by public exchange order book (this is not applicable in OTC).
There are various types of OTC instruments, this may include stocks, bonds, derivatives, digital assets and structured products. There are different characteristics of the OTC markets. Price is not a stable factor, it can be deliberated on and it is between the dealer directly and the individual or organization. Negotiation is a feature that is found in OTC, but not in markets under the public exchange order book.
The conditions of purchase or sales can be negotiated and agreed upon before the exchange takes place. Liquidity is how easy an asset can be bought or sold without losing its value. OTC trading has a lower liquidity as everything does not follow a single and constant condition, following from the conditions of sale to the price paid.
Advantages of OTC Trading Instruments
Wider range of instruments
OTC allows for customized trades and contracts in the market that have not been made available in the public exchange markets including bespoke contracts. This is a major advantage of over-the-counter trading.
Flexibility
Since the OTC market is less regulated by public exchange securities, the terms and conditions for the sale and purchase of the digital assets can be negotiated, including the price, settlement terms and so on.
Confidentiality and privacy for large orders
Businesses and organizations might be involved in a large-scale purchase of assets, OTC provides a means to keep this transaction away from the public. This prevents front-running and also, prevents any negative effect on the markets.
Potentially lower transaction costs depending on infrastructure
Transactions through the OTC desks will reduce the costs that will be incurred as a result of multiple exchange trading fees, if executed through public exchange order books.
Ability to execute large deals without affecting public markets
An over-the-counter (OTC) trade is settled privately so it will necessarily have zero effect on the market visible to the public, especially if the transaction were to be in large capacity.
Disadvantages and Risks of OTC Trading
Counterparty Risk
Absence of a central non-clearinghouse, as ensured in public order book may lead to a party bearing the loss if the other party refuses to keep to the end of the deal. No regulation is put in place to make sure the terms and conditions are carried out as expected.
Lower Liquidity for many instruments
As many instruments that can be traded on OTC markets, this does not guarantee that a reasonable price might be paid for it as searching for buyers may be difficult and desperation can lead to high slippage.
Uneven Access for retail traders
Retail traders do not have access to the information of the markets or the things that are being done, as the OTC was created initially because of large institutions and businesses.
Limited transparency vs exchange markets
Since the affairs of the OTC markets are not seen by the public, true market prices or competition in the market might be difficult to know and take records of.
Wider spreads and pricing uncertainty
Prices on the OTC markets might be inflated because there is no single guiding rule and each price is brought to the table by the one that wants to sell them. Prices may be negotiable but does not stop the fact that it might have been over-inflated from the beginning.
Use Cases and Practical Scenarios
1. Institutional trades between banks, brokers and funds
The Foreign Exchange (Forex) market is an over-the-counter (OTC) marketplace. International banks are executed OTC via telephone or electronic networks. This is to manage capital, settle currency needs and all other reasons.
2.Fintech Platforms that offer customized OTC derivatives
A specialized trading platform can bring about customized contracts, which may be option or call and it will only be traded on that platform. This is not listed in any other future exchange platforms.
3.Private deals for corporate bonds or structured products
When a business wants to raise capital, it can be decided that the bonds will be sold to a particular set of private investors, rather than going public. This is also supported in SEC Rule 144A (which enables companies to raise capital quickly by selling bonds or other securities privately to large institutional investors instead of going through a public offering).
4.How OTC is used to manage large exposures or hedge risks
A large corporation can decide to lock in an exchange today because of the unforeseen circumstances of currency fluctuations. An oil company can enter an OTC forward contract with an investment bank to sell their oil at a fixed price, guaranteeing their revenue without using future exchange.
Technology as the Foundation of Secure OTC Markets
In this fast-paced world in which technology is the order of the day, it should be noted that technology is the gateway to securing OTC markets. Technology helps to provide secure networks that will promote smooth transactions between the buyer and seller. Technology also can help reduce the effect that absence of central non-clearing houses brings through advanced systems that can hold people accountable.
Technology automates these processes to ensure they conform to legal and regulatory requirements. OTC desks need highly reliable systems because a failed one can bring about failed trades and significant financial losses.
WL Global Solutions provide secure infrastructure (reliable and protected systems for private trading) by detecting and mitigating attack patterns in real time.
Conclusion
OTC markets have various advantages ranging from flexibility of conditions, privacy to wider range of OTC instruments such as stocks, bonds. The disadvantages are also not to be overlooked as they are equally important when compared to CEX, they include lower liquidity for many instruments, limited transparency vs exchange markets to counterparty risk.
Proper technology is the way forward to a better OTC market as it will help to mitigate risks and encourage compliance of buyers and sellers to the conditions of sale. This will also ensure the smooth transactions in OTC markets by the use of the secure networks that will be made available through technology throughout negotiation and purchase periods.
Don't let counterparty risk compromise your block trades. Request a demo of the WL Global Solutions to see how high grade technology can guarantee extension and compliance for your most sensitive OTC deals.
FAQ
Q1: Is OTC trading regulated?
Yes, it is.
This is not as tightly regulated like CEX but the regulation also depends on the country, the OTC instruments and the platform used.
Q2: What instruments are usually traded OTC?
Stocks, Bonds, Derivatives, Structured products and a lot more.
Q3: Is OTC safer or riskier than exchange trading?
OTC is riskier than exchange trading because it works outside the regulated environment of public exchange.
Q4: How do brokers get access to OTC liquidity?
Brokers get access to liquidity through various channels such as liquidity providers, OTC desks and so on.
Q5: What is the difference between OTC and dark pools?
Dark Pools match anonymous orders inside a private system; OTC trades are negotiated privately between two parties outside any trading venue.
Dark pools have hidden order books; OTC does not possess any.
Dark pools are less transparent than public; OTC is completely private
Dark pools' prices are mid-prizes of public markets; OTC's prices are completely negotiable.