Understanding the true meaning of OTC over-the-counter trading: the financial world outside the exchange

Investors often hear the term “OTC,” but what exactly does OTC mean? Many people are unclear about the difference between over-the-counter trading and centralized exchanges. This article will provide an in-depth explanation of the meaning, operation mechanism, and characteristics of OTC, helping investors make more informed decisions.

The True Meaning and Definition of OTC

OTC stands for “Over The Counter,” which is called “場外交易” in Chinese. Its essential meaning refers to transactions conducted outside of centralized markets (such as securities exchanges). Simply put, OTC means that buyers and sellers do not rely on a unified trading venue but negotiate directly through banks, brokerages, phone calls, or electronic systems via dispersed channels.

This trading method is also known as “over-the-counter trading,” “desk trading,” or “OTC market.” Unlike the uniform bidding mechanism of centralized markets, OTC prices are entirely negotiated freely by both parties, and counterparties can be banks, securities firms, corporations, or individual investors.

What types of companies choose OTC trading?

Companies capable of OTC trading generally fall into two categories: one is small to medium-sized enterprises or startups that do not qualify for listing and cannot meet the strict requirements of exchanges; the other is companies that are eligible for listing but actively choose OTC to avoid the competitive pressure from excessive information disclosure.

With the development of the internet and the expansion of international financial markets, investors’ demand for trading convenience has increased, leading to rapid growth in the OTC market. However, compared to centralized markets, OTC prices are less transparent, and due to the lack of strict trading rules and regulatory systems, trading risks are relatively higher, and participants may face counterparty credit risks.

What can be bought and sold in OTC?

The product types in OTC trading are far more diverse than in centralized markets:

Stocks — Besides stocks listed on exchanges, OTC markets mainly involve stocks of startups and small businesses that have not applied for listing, which constitute the largest investment segment in OTC.

Bonds — Due to the large issuance volume, variety, and infrequent trading of bonds, OTC markets are more suitable for bond circulation than centralized exchanges.

Derivatives — Contracts such as options, futures, and spread contracts can all be traded OTC.

Foreign Exchange — Currency transactions conducted on various trading platforms fall under OTC trading.

Cryptocurrencies — Popular digital assets can be traded extensively in OTC markets, which is often difficult to achieve in dedicated cryptocurrency markets.

The Operation Mechanism of Taiwan’s OTC Market

Taiwan’s stock market is divided into two levels: the “Securities Exchange” and the “OTC Market” (also called the “Gretai” or “OTC Center”). The OTC index (also known as the Gretai Index) compiled by the OTC Center reflects the overall condition of Taiwan’s OTC stock market, and investors often observe this index to gauge the trend of small and medium-sized stocks.

The government established the OTC Center to balance development—strict listing requirements can hinder corporate growth, but a completely unregulated environment also carries risks. Therefore, the OTC Center has relaxed listing conditions, requiring only recommendations from two or more guiding securities firms to list, and if a company shows significant improvement within six months, it can apply for transfer to the main or OTC markets.

However, this relatively lenient environment has also attracted speculators who impersonate unscrupulous brokers, recommending high-risk targets and harvesting investors. Therefore, choosing reputable brokers is crucial.

The Trading Process of OTC

The operation of Taiwan’s OTC market is similar to that of the listing market, with the following steps:

Step 1 — Investors place orders through brokers, in the same way as purchasing listed stocks.

Step 2 — Orders are uploaded to the OTC Center’s automated matching system (ATS), which matches trades based on price priority and time priority, with technical rules synchronized with the listing market.

Trading hours — Pre-market 08:30-09:00, regular trading 09:00-13:30, after-hours pricing 13:40-14:30, with a call auction every 5 seconds.

Price fluctuation limits — ±10%, the same as listed stocks.

Settlement system — T+2, identical to listed stocks.

OTC stocks must comply with information disclosure regulations, making them more transparent than the emerging OTC market. Due to better liquidity and the same system as listed stocks, the threshold for retail investors to participate in OTC stocks is not high. However, because of the smaller enterprise scale and susceptibility to news and market sentiment, investors should be cautious of volatility risks.

Core Differences Between OTC and Centralized Exchanges

Product Standards — Centralized trading involves standardized products, similar to currency exchange at banks with uniform standards; OTC trading involves non-standardized products, like pawnshops where each item varies, but the variety of tradable goods is greater.

Trading Mode — Call auction ensures fairness but offers limited profit margins; negotiated trading has no public restrictions, with buyers and sellers agreeing directly, where information is more important than capital.

Product Diversity — Centralized trading requires standardization and sufficient market size, limiting product variety; OTC trading is highly diverse.

Regulation and Security — Central exchanges are approved and regulated by the government; OTC markets are mostly operated by brokers, with only some under formal regulation, and there is a risk of fraud through fake exchanges.

Transparency and Information — Centralized trading publicly discloses all transaction data; OTC markets do not, leading to information asymmetry, where insiders can profit, and inexperienced investors may suffer losses.

Trading Volume and Liquidity — Centralized exchanges attract international capital due to regulation and clear rules, resulting in high trading volume and liquidity; OTC trading has lower volume and liquidity.

Advantages of OTC Trading

✔️ Wide Investment Options — Access to derivatives, binary options, contracts for difference (CFDs), forex trading, and more.

✔️ Flexible Trading Methods — Product specifications and trading methods can be customized according to investment goals, with high adaptability.

✔️ Leverage Flexibility — Traditional markets have limited leverage, but OTC offers various leverage options to amplify returns.

✔️ Enhanced Security — Modern OTC markets have optimized multi-layer security measures, comparable to centralized markets; some licensed brokers are more professional and reliable.

Risks and Hidden Dangers of OTC

❌️ Lack of Regulation — OTC markets lack unified regulations; laws and oversight are relatively loose, making it easier for fraudulent brokers to infiltrate. Listed companies and securities must comply with strict rules, but many non-compliant companies and securities can only trade OTC.

❌️ Insufficient Liquidity — OTC securities have lower liquidity than centralized exchanges, and investors may find it difficult to exit at desired prices.

❌️ Market Volatility Risks — Affected by market fluctuations, most OTC investors cannot access the transparent information provided by centralized exchanges.

❌️ Credit and Fraud Risks — Direct transactions between buyers and sellers face counterparty credit risks; malicious actors may use false information to deceive investors.

❌️ Liquidity and Price Risks — Some products experience large price swings and low liquidity, making it easy to get trapped.

Is OTC Really Unsafe?

OTC trading indeed carries higher risks than centralized exchanges, but it is not entirely unsafe. The key lies in choosing the right trading platform and broker.

First, ensure the broker is secure — Verify whether it is under multiple layers of regulation and has strong risk management capabilities.

Second, select mature products — Understand the spreads, liquidity, withdrawal processes of forex, cryptocurrencies, and other products, and conduct comprehensive assessments.

Understand protective measures — Legitimate trading platforms offer risk assessments, KYC identity verification, complaint mechanisms, and other investor protection measures, which help reduce trading risks.

Since OTC markets lack the regulation of centralized exchanges, risks are indeed higher. However, for investors who understand its true meaning and master risk management strategies, choosing reliable platforms and mature products can still allow reasonable investment returns in OTC trading.