Securities Traded OTC

The OTC Markets section covers securities that trade outside traditional exchanges, their characteristics, and how they differ from exchange-listed securities. This content appears frequently on the exam through scenario-based questions about market structure, trading mechanics, and regulatory differences. Understanding which securities trade OTC and why is essential for answering questions about market access, liquidity, and investor protection.

Core Concepts

Over-the-Counter Market Structure

The OTC market is a decentralized network where securities trade directly between dealers and investors rather than through a centralized exchange like the NYSE or Nasdaq. Trades occur through dealer networks, electronic platforms, and direct negotiations between parties.

OTC markets operate through a negotiated dealer market where dealers act as market makers by maintaining inventories of securities and quoting both bid and ask prices. When you buy an OTC security, you're typically buying from a dealer's inventory rather than from another investor through an exchange matching system.

• Dealers quote bid prices (what they'll pay to buy) and ask prices (what they'll sell for)
• The spread between bid and ask represents the dealer's profit
• Multiple dealers can compete by posting different quotes for the same security
• No centralized trading floor or order book exists
• Prices are discovered through dealer competition and negotiation

When to Use This

• When exam questions ask you to identify whether a trade occurs on an exchange or OTC based on the description of how the trade executes
• When distinguishing between auction markets (exchanges) and negotiated markets (OTC)
• When a question describes buying "from a dealer" or mentions bid-ask spreads as the primary pricing mechanism
• When you need to explain why certain securities have wider spreads (less liquid OTC securities have wider dealer spreads)

Securities That Trade OTC

Corporate bonds are the primary securities trading OTC. The vast majority of corporate bond trading occurs in the OTC market rather than on exchanges because bonds have many different issues with varying maturities, coupon rates, and features that make centralized trading impractical.

Municipal bonds (both general obligation and revenue bonds) trade exclusively OTC. Each municipal bond issue is unique with specific features tied to the issuing municipality, making dealer networks the most efficient trading mechanism.

Government securities including U.S. Treasury bills, notes, and bonds trade OTC through a network of primary dealers. These are among the most liquid securities in the world despite trading OTC.

Non-Nasdaq equity securities trade OTC when they don't meet listing requirements for major exchanges. These include:

• Pink Market securities (formerly Pink Sheets) - the most speculative tier with minimal reporting requirements
• OTCQB - middle tier requiring some financial reporting and verification
• OTCQX - highest tier of OTC equity trading with the most stringent requirements
• Grey Market - securities with no market makers and extremely limited information

Foreign securities that aren't listed on U.S. exchanges often trade OTC through American Depositary Receipts (ADRs). Some ADRs trade on exchanges, but many trade exclusively OTC.

Options on certain securities may trade OTC as customized contracts between parties, though most standardized options trade on exchanges.

When to Use This

• When an exam question asks where a specific type of security trades - if it's a bond, assume OTC unless told otherwise
• When comparing liquidity across markets - Treasury securities are highly liquid despite being OTC; Pink Market stocks are illiquid
• When questions involve municipal bonds - they always trade OTC
• When determining regulatory requirements - OTC equity securities in different tiers have different disclosure requirements

OTC Trading Platforms and Systems

OTC Link ATS (formerly Pink Link) operated by OTC Markets Group is the primary electronic quotation system for OTC equity securities. Dealers post their quotes electronically, and other dealers and investors can see these quotes and execute trades.

The system provides three tiers of OTC equity securities based on disclosure and financial standards:

• OTCQX - requires audited financial statements, minimum bid price of $0.01, and meeting specific financial standards
• OTCQB - requires current financial reporting and annual verification but less stringent than OTCQX
• Pink Market - no financial disclosure requirements; divided into Current Information, Limited Information, and No Information categories

Grey Market securities don't appear on OTC Link and have no market makers posting quotes. These securities have extremely limited trading.

When to Use This

• When ranking OTC equity securities by quality or disclosure requirements - OTCQX is highest quality, Grey Market is lowest
• When questions involve investor protection or information availability in OTC markets
• When comparing requirements for different OTC tiers - OTCQX has the most stringent standards
• When identifying which OTC securities have the most speculative characteristics

Regulatory Framework for OTC Securities

OTC securities face different regulatory oversight than exchange-listed securities. While the SEC regulates OTC markets, OTC equity securities often have reduced reporting requirements compared to exchange-listed stocks.

FINRA Rule 6432 requires members to use OTC Link ATS or another FINRA-approved quotation medium to display quotations in OTC equity securities. Dealers cannot simply quote prices privately without using an approved system.

Rule 15c2-11 (the "piggyback rule") prohibits broker-dealers from publishing quotations for OTC equity securities unless they have reviewed specific information about the issuer. This prevents brokers from quoting completely unknown or fraudulent securities.

• Brokers must review company financial statements, business description, and other basic information
• Exceptions exist for securities already quoted or for certain foreign securities
• The rule aims to prevent pump-and-dump schemes in thinly traded securities

When to Use This

• When exam questions ask about dealer obligations before quoting OTC securities
• When identifying which rule prevents dealers from quoting completely unknown securities
• When questions involve FINRA's oversight of OTC equity trading
• When comparing regulatory requirements between exchange-listed and OTC securities

OTC Trading Characteristics

Liquidity in OTC markets varies dramatically. U.S. Treasury securities have exceptional liquidity with tight bid-ask spreads, while Pink Market stocks may have wide spreads and infrequent trades.

Price transparency is generally lower in OTC markets compared to exchanges. While quotes are available through electronic systems, not all completed trades are immediately reported with the same detail as exchange trades.

Counterparty risk is more significant in OTC markets because you're trading directly with dealers rather than through an exchange clearing system. If a dealer fails, trades could be affected.

• OTC equity trades settle in T+2 (trade date plus two business days), same as exchange-listed stocks
• OTC bond trades typically settle in T+2 for corporate bonds and T+1 for Treasury securities
• Municipal bonds generally settle in T+2
• Dealers maintain inventory risk by holding securities before reselling them

When to Use This

• When comparing settlement periods across different security types
• When questions ask about differences in transparency between exchange and OTC markets
• When identifying risks specific to OTC trading versus exchange trading
• When determining liquidity characteristics based on market structure

Dealer Quotations and Pricing

OTC dealers provide two-sided quotes with a bid price (what they'll pay to buy from you) and an ask price (what they'll charge to sell to you). The difference is the bid-ask spread, which represents the dealer's gross profit.

When you see a quote like "42.50 - 42.75," the first number (42.50) is the bid and the second (42.75) is the ask. If you're selling, you receive the bid price; if you're buying, you pay the ask price.

• Dealers make money on the spread, not commissions
• More liquid securities have tighter spreads (smaller difference between bid and ask)
• Less liquid or riskier securities have wider spreads to compensate dealers for inventory risk
• Inside market or best bid and offer (BBO) refers to the highest bid and lowest ask among all dealers
• Dealers must honor their quoted prices for the stated size

When to Use This

• When calculations ask for the price an investor pays or receives - use ask when buying, bid when selling
• When determining dealer profit - it's the spread multiplied by the number of shares/bonds
• When questions compare costs between exchange trades (with commissions) and OTC trades (with spreads)
• When identifying which market structure benefits investors more in terms of pricing

Commonly Tested Scenarios / Pitfalls

1. Scenario: A question describes an investor purchasing a municipal bond and asks where the transaction occurred. Students see "bond" and might think it could be either exchange or OTC.

Correct Approach: Municipal bonds trade exclusively OTC. Select the OTC market as the answer without second-guessing.

Check first: Identify the security type - if it's a bond (corporate, municipal, or government), assume OTC unless the question explicitly states otherwise.

Do NOT do first: Don't assume all securities trade on both exchanges and OTC markets. The exam expects you to know that bonds predominantly trade OTC.

Why other options are wrong: Exchange options would be incorrect because municipal bonds lack the standardization needed for exchange trading, and each issue is unique to its municipality.

2. Scenario: An exam question provides a dealer quote of "25.40 - 25.60" and asks what price an investor pays when buying 100 shares. Students might average the two numbers or use the wrong side of the quote.

Correct Approach: When buying, the investor pays the ask price (the higher number). The answer is 25.60 × 100 = $2,560.

Check first: Determine whether the investor is buying or selling - this dictates which side of the quote applies.

Do NOT do first: Don't use the bid price for a purchase or calculate an average between bid and ask. The investor never gets the average - they always get the worse price.

Why other options are wrong: Using the bid (25.40) would be the price if the investor were selling, not buying. Averaging gives a price that neither party uses in the actual transaction.

3. Scenario: A question asks which OTC equity market tier has the most stringent disclosure requirements. Students might confuse the ranking or think Pink Market is highest quality because "pink" sounds better than "grey."

Correct Approach: OTCQX has the highest standards, followed by OTCQB, then Pink Market, with Grey Market having no market makers at all.

Check first: Remember the hierarchy: OTCQX → OTCQB → Pink → Grey (descending order of quality and requirements).

Do NOT do first: Don't assume alphabetical order or guess based on name associations. The ranking is specific and tested frequently.

Why other options are wrong: Pink Market and Grey Market securities have minimal or no disclosure requirements, making them speculative and high-risk compared to OTCQX.

4. Scenario: A question describes U.S. Treasury securities and asks about their liquidity characteristics. Students might assume OTC securities are always illiquid compared to exchange-traded securities.

Correct Approach: U.S. Treasury securities are among the most liquid securities globally despite trading OTC through a dealer network of primary dealers.

Check first: Separate the concept of OTC structure from liquidity - OTC doesn't automatically mean illiquid. Treasury securities prove this exception.

Do NOT do first: Don't assume all OTC securities are illiquid. The market structure (OTC vs. exchange) doesn't solely determine liquidity.

Why other options are wrong: Illiquid options would be incorrect because Treasury securities have tight bid-ask spreads, high trading volume, and numerous active dealers providing continuous quotes.

5. Scenario: An exam question asks about Rule 15c2-11 and what it requires of broker-dealers before publishing quotes for OTC equity securities. Students might confuse it with other disclosure rules.

Correct Approach: Rule 15c2-11 requires broker-dealers to review specific company information (financials, business description, etc.) before publishing quotes, preventing the quotation of completely unknown or fraudulent securities.

Check first: Identify that this rule specifically governs when dealers can begin quoting OTC equity securities, not their ongoing obligations after quotes are established.

Do NOT do first: Don't confuse this with general anti-fraud rules or ongoing disclosure requirements. This rule specifically addresses the initiation of quotations.

Why other options are wrong: Options suggesting brokers can quote any security without review violate Rule 15c2-11. Options about ongoing reporting confuse initial quotation requirements with continuous disclosure rules.

Step-by-Step Procedures or Methods

Task: Calculating investor cost or proceeds in an OTC dealer transaction

1. Identify whether the investor is buying or selling the security
2. Locate the dealer's two-sided quote (bid - ask format)
3. Select the appropriate price: ask price if buying (higher number), bid price if selling (lower number)
4. Multiply the applicable price by the number of shares or bonds
5. For bonds, remember to add accrued interest if the question mentions it
6. The result is the total amount the investor pays (when buying) or receives (when selling)

Task: Determining dealer spread and profit

1. Identify the bid and ask prices from the dealer's quote
2. Calculate the spread per unit: Ask price - Bid price = Spread
3. Multiply the spread by the number of units traded
4. The result is the dealer's gross profit from the transaction
5. Remember that dealers earn the spread whether they facilitate a customer buy or sell

Task: Identifying the appropriate OTC market tier for an equity security

1. Check if the security has market makers and quotes - if no, it's Grey Market
2. Determine if the company provides audited financials and meets financial standards - if yes and meets highest standards, it's OTCQX
3. If the company reports financial information but doesn't meet OTCQX standards, it's likely OTCQB
4. If there's minimal or no financial disclosure but quotes exist, it's Pink Market
5. Use disclosure level and quality standards as the primary distinguishing factors

Practice Questions

Q1: Which of the following securities trade primarily in the OTC market?
(a) Common stocks listed on the NYSE
(b) Corporate bonds
(c) Exchange-traded funds (ETFs)
(d) Standardized equity options

Ans: (b)
Corporate bonds trade primarily OTC through dealer networks because each bond issue has unique characteristics (maturity, coupon, features) that make centralized exchange trading impractical. NYSE-listed stocks, ETFs, and standardized options all trade on exchanges where centralized matching is efficient for standardized products.

Q2: A dealer quotes a stock at 18.25 - 18.50. An investor wants to purchase 500 shares. What price will the investor pay per share?
(a) 18.25
(b) 18.375
(c) 18.50
(d) The price depends on negotiation

Ans: (c)
When purchasing from a dealer, the investor pays the ask price (the higher number in the quote), which is 18.50. The bid price (18.25) is what the investor would receive if selling to the dealer. The midpoint (18.375) is not used in actual transactions, and while some negotiation might occur, the quoted ask price is what the investor pays at the dealer's quoted size.

Q3: Which OTC equity market tier has the highest disclosure and financial standards?
(a) Pink Market
(b) OTCQB
(c) OTCQX
(d) Grey Market

Ans: (c)
OTCQX requires the most stringent standards including audited financial statements and meeting specific financial criteria. OTCQB has moderate requirements, Pink Market has minimal disclosure requirements, and Grey Market securities have no market makers and essentially no standards.

Q4: What does Rule 15c2-11 require of broker-dealers regarding OTC equity securities?
(a) They must execute all customer orders within 24 hours
(b) They must review specific company information before publishing quotes
(c) They must maintain insurance for all OTC transactions
(d) They must register all OTC securities with the SEC

Ans: (b)
Rule 15c2-11 requires broker-dealers to review specific information about the issuer (financial statements, business description, etc.) before publishing quotations for OTC equity securities. This prevents dealers from quoting completely unknown or potentially fraudulent securities. The rule doesn't address execution timing, insurance requirements, or SEC registration of the securities themselves.

Q5: A dealer buys a bond from a customer at 98 and sells it to another customer at 98.50. The dealer's profit per bond is:
(a) $0.50
(b) $5.00
(c) $50.00
(d) $500.00

Ans: (b)
Bond prices are quoted as a percentage of par value ($1,000). The spread is 98.50 - 98 = 0.50 points. Each point equals $10, so 0.50 points = $5.00 profit per bond. Answer (a) incorrectly treats the spread as dollars, (c) treats each point as $100 instead of $10, and (d) would represent a full point difference.

Q6: Which statement about OTC markets is correct?
(a) All OTC securities are illiquid compared to exchange-traded securities
(b) OTC markets operate through centralized order matching like exchanges
(c) U.S. Treasury securities trade OTC through a dealer network
(d) Municipal bonds must trade on exchanges due to SEC regulations

Ans: (c)
U.S. Treasury securities trade OTC through primary dealers despite being among the most liquid securities in the world. Statement (a) is incorrect because liquidity varies widely in OTC markets - Treasuries are highly liquid while some Pink Market stocks are extremely illiquid. Statement (b) is wrong because OTC markets are decentralized dealer networks, not centralized matching systems. Statement (d) is incorrect because municipal bonds trade exclusively OTC, not on exchanges.

Quick Review

• Corporate bonds, municipal bonds, and government securities trade primarily or exclusively OTC through dealer networks
• OTC equity tiers ranked by quality: OTCQX (highest) → OTCQB → Pink Market → Grey Market (lowest/no market makers)
• When buying from a dealer, you pay the ask price (higher number); when selling, you receive the bid price (lower number)
• Dealer spread = Ask price - Bid price, which represents the dealer's gross profit
• Rule 15c2-11 requires broker-dealers to review company information before publishing quotes for OTC equity securities
• OTC markets are negotiated dealer markets, not auction markets - you trade with dealers maintaining inventory, not other investors
• U.S. Treasury securities are highly liquid despite trading OTC - market structure doesn't solely determine liquidity
• OTC equity securities settle T+2, same as exchange-listed stocks; most bonds also settle T+2 except Treasuries at T+1
• FINRA Rule 6432 requires members to use OTC Link ATS or another approved quotation system for OTC equity quotes
• OTC markets generally have lower price transparency and higher counterparty risk than exchange markets, though this varies significantly by security type