An over-the-counter (OTC) securities market is a secondary market through which buyers and sellers of securities (or their agents or brokers) consummate transactions. Secondary markets (securities markets where previously issued securities are re-traded) are mainly organized in two ways. One is to form an organized exchange, where buyers and sellers of securities (mostly represented by their agents or brokers) meet at a central place to conduct transactions. The New York Stock Exchange (NYSE), the American Stock Exchange (located in New York) and the Chicago Board of Trade for Commodities are examples of major organized exchanges in the United States. An over-the-counter securities market provides an alternative way of organizing a secondary market—in this, dealers with inventories of securities at different geographical locations are in contact with each other through a computer network. In other words, these dealers of securities are ready to buy or sell securities over the counter to anyone who contacts them and accepts their quoted price. One may thus describe an over-the-counter securities market as an electronic market. The National Association of Securities Dealers Automated Quotations System (now generally referred to simply as "the Nasdaq") is an example of an over-the-counter securities market in the United States.
The NASDAQ over-the-counter market was established in 1971. Before the NASDAQ was instituted, trading in OTC securities used to be a rather haphazard operation—individual broker/dealer firms bought and sold securities for their own accounts. In doing so, they acted as dealers, not brokers. For larger OTC stocks, a dozen or so firms quoted bid and asked prices for securities—account executives relied on these quoted prices in buying and selling securities for customers. However, for many small over-the-counter securities, only a couple of firms made a market—that is, quoted bid and asked prices. Thus, one could never be sure if one got the best price. Moreover, record keeping was done on "pink sheets" that recorded bids and offers, not actual trades. The computer system replaced the telephone communications mechanism in 1971 and provided a far better method of uncovering the best price.
Since over-the-counter securities dealers are in computer contact with each other, they know the prices set by one another. As a result, an OTC market is very competitive and is not significantly different from a securities market that utilizes an organized exchange. Nevertheless, it is fair to say that the stocks of many large and well known corporations are traded on the NYSE, often called the Big Board. This provides the NYSE with high visibility—it is considered the real marketplace. The trading in shares of approximately 2,000 corporations takes place on the floor of the exchange; transactions are recorded on an electronic ticker tape flashed on the floor itself as well as in brokerage offices throughout the country. As a consequence of the emphasis on Big Board stocks, the common stocks listed on over-the-counter markets are often called secondary issues.
There are over-the-counter securities markets for a variety of financial securities or instruments. The most widely followed is the over-the-counter market in common stocks. While many large corporations have their stock traded at the New York Stock Exchange, not all common stocks traded in the NASDAQ market are small. For example, IBM Corp., AT&T, or General Motors Corp. stocks (that are also part of the 30 common stocks included in the widely followed Dow Jones Industrial Average index) are traded on the Big Board. However, many widely known common stocks, such as Intel Corp. or MCI Communications Corp., are traded in the over-the-counter stock market. Both the NYSE and the NASDAQ market have a large number of small common stocks.
The financial market in U.S. government bonds is also set up as an over-the-counter market. It is important to note that the U.S. government bond market has a larger trading volume than the NYSE. The OTC market in government bonds was established by approximately 40 dealers in Treasury bonds who were ready to buy and sell Treasury securities.
Over-the-counter securities markets exist in other financial instruments, in addition to common stocks and government bonds. Markets for several money-market financial instruments are also established as over-the-counter markets. For example, negotiable certificates of deposit, banker's acceptances, and federal funds are all traded in over-the-counter securities markets. There are OTC markets in non-money market instruments as well. These include trading in a foreign exchange .
The relatively newly issued financial instrument known as a derivative is also traded in the OTC securities markets. Peter Abken (in Economic Review) discusses the implications of derivative securities trading in the over-the-counter markets. He points out that, aside from their complexity, the largely unregulated character of the OTC derivatives markets sets them apart from the financial markets for other securities, due to their extremely rapid growth and fast pace of innovation. In recent years, over-the-counter derivatives have become a mainstay of financial risk management and are expected to continue growing in importance, according to Abken. The current structure of the OTC markets is being closely examined, and a set of recommendations has been made. The central policy question in derivatives regulation debated by Abken is whether further federal regulation is appropriate, or whether the existing structure can oversee these markets.
The bid price is the amount that a securities dealer must pay to obtain a security, while the ask price is the amount that a securities dealer receives after selling it. Frederic S. Mishkin commented in The Economics of Money, Banking, and Financial Markets that "you might want to think of the bid price as the 'wholesale price' and the asked price as the 'retail' price."
The ask price for securities is higher than the bid price. The difference between the two prices provides the dealer with his profit margin, compensating the dealer for his work. This compensation amount is known as the dealer's spread. Since securities can rise or fall in price during the period that the dealer owns them, thus impacting a dealer's ability to secure an acceptable asking price, this business can be a tricky one.
[ Anandi P. Sahu , Ph.D. ]
Abken, Peter A. "Over-the-Counter Financial Derivatives: Risky business?" Economic Review [Federal Reserve Bank of Atlanta], March/April 1994.
Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 5th ed. Reading, PA: Addison-Wesley, 1998.
Ritter, Lawrence S., William L. Silber, and Gregory F. Udell. Principles of Money, Banking, and Financial Markets. 9th ed. Reading, PA: Addison-Wesley, 1997.