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Over-the-Counter (OTC) Securities

Abanti Chattopadhyay

5 min Read

27 Dec 2020

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Introduction

Over-the-Counter (OTC) securities are financial instruments that are not traded on centralized stock exchanges like the NSE or BSE. Instead, these securities are traded directly between buyers and sellers through dealers, brokers, or financial institutions.

OTC trading occurs over the phone, electronically, or through private negotiations. It is widely used for equities, bonds, derivatives, and foreign exchange transactions. In India, OTC markets play a significant role in corporate bond trading, debt instruments, and derivative contracts.

This article explores the concept of OTC securities, how they function, their advantages, risks, and their impact on the Indian financial market.

What Are Over-the-Counter (OTC) Securities?

OTC securities are financial assets traded outside of formal stock exchanges. Unlike exchange-traded securities, which have standardized prices and regulations, OTC securities are traded privately between investors and financial intermediaries.

These transactions typically involve direct communication between brokers, banks, and institutional investors.

Key Characteristics of OTC Securities

No centralized exchange – Transactions happen privately between buyers and sellers.
Less transparency – Prices are negotiated individually, leading to variations in pricing.
Wider range of assets – Includes corporate bonds, derivatives, foreign exchange, and small-cap stocks.
Regulated differently – OTC markets have fewer restrictions compared to stock exchanges, making them flexible but riskier.

For example, if an investor wants to buy ₹10 crore worth of corporate bonds, they may contact a dealer or broker directly instead of executing the trade on the NSE or BSE.

Types of Securities Traded Over-the-Counter (OTC)

1. OTC Equities (Unlisted Stocks)

Stocks of small or emerging companies not listed on major exchanges.
Companies that do not meet the listing requirements of NSE/BSE trade OTC through brokers.
Example: Startups and SMEs in India trade their shares through the OTC market before listing on stock exchanges.

2. OTC Bonds (Corporate and Government Bonds)

Corporate bonds, municipal bonds, and government securities (G-Secs) are commonly traded OTC.
Institutional investors negotiate bond purchases directly with financial dealers.
Example: A mutual fund buying ₹50 crore worth of PSU bonds through an OTC transaction.

3. OTC Derivatives

Includes forwards, swaps, and options that derive their value from an underlying asset (stocks, commodities, interest rates, forex).
Example: A company uses interest rate swaps to hedge loan repayment risks, conducted through OTC transactions.

4. Foreign Exchange (Forex) Transactions

Banks, financial institutions, and corporate entities trade currencies OTC.
Example: An Indian importer directly buys USD from an OTC forex dealer at negotiated rates.

How Do OTC Markets Work?

OTC securities are traded through a decentralized dealer network, rather than a stock exchange. Transactions are executed in the following ways:

1. Dealer-Broker Model

Dealers buy and sell securities from their own inventory and offer bid-ask prices to investors.
Brokers act as intermediaries, finding buyers and sellers for specific securities.

2. Bilateral Negotiation

Institutional investors and large corporations negotiate terms privately with counterparties.
Example: A mutual fund manager directly contacts a bond dealer to purchase debt securities.

3. Electronic Trading Platforms

Some OTC securities are traded through electronic networks (OTC exchanges or interbank trading platforms).

Example: RBI’s Negotiated Dealing System (NDS) facilitates government bond OTC trading.

Advantages of OTC Securities

1. Flexibility in Trading

Investors can negotiate custom agreements for securities that are not available on stock exchanges.

2. Access to Alternative Investments

OTC markets provide exposure to corporate bonds, derivatives, and forex trades that may not be available on public exchanges.

3. Lower Listing and Compliance Costs

Companies that cannot afford high listing fees on NSE/BSE can issue securities in the OTC market.

4. Customized Trading Contracts

Unlike standardized exchange contracts, OTC derivatives can be customized based on investor needs.
For example, an exporter hedging forex risks can negotiate an OTC forward contract with a bank instead of using exchange-traded futures.

Risks Associated with OTC Securities

1. Lack of Price Transparency

Unlike stock exchanges, OTC markets do not display real-time price quotes, making it harder for investors to assess fair value.

2. Counterparty Risk (Default Risk)

OTC trades are not guaranteed by exchanges, increasing the risk that one party may default on the transaction.
Example: A company issuing OTC bonds may fail to repay investors if financial conditions deteriorate.

3. Lower Liquidity

Some OTC securities have fewer buyers and sellers, making it difficult to exit investments quickly.

4. Regulatory Risks

OTC securities are less regulated than exchange-listed securities, increasing the risk of fraud or price manipulation.
For example, during the Yes Bank crisis in 2020, some OTC bondholders faced losses due to lack of market regulation.

OTC Market Regulation in India

The Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI) oversee OTC trading regulations to ensure market stability and investor protection.

1. RBI Regulation of OTC Bonds and Forex

RBI regulates OTC corporate bond trading through the Electronic Trading Platform (ETP).
Forex transactions are monitored under Foreign Exchange Management Act (FEMA).

2. SEBI Oversight on Unlisted Securities and Derivatives

SEBI requires higher risk disclosures for OTC derivatives.
Recent SEBI guidelines restrict mutual funds from taking excessive exposure to OTC debt instruments.

3. RBI’s Negotiated Dealing System (NDS) for Government Bonds

RBI launched the NDS trading platform for OTC bond transactions, improving transparency in the debt market.

How to Invest in OTC Securities in India?

1. Through Brokers and Dealers

Investors can trade OTC corporate bonds and derivatives by contacting licensed brokers and dealers.

2. Using RBI’s Negotiated Dealing System (NDS)

Institutional investors can trade government securities (G-Secs) OTC through RBI’s NDS.

3. Via Mutual Funds and Institutional Funds

Many debt mutual funds invest in OTC bonds and corporate debt instruments, providing retail investors with indirect exposure.

4. Participating in Private Placements

Companies issue OTC bonds via private placements, allowing institutional investors to subscribe.

Conclusion

Over-the-Counter (OTC) securities play a crucial role in India’s bond, derivatives, and forex markets, offering flexibility and access to alternative investments. While OTC markets lack transparency and regulation, they provide unique opportunities for institutional investors and corporations.

For retail investors, investing in OTC securities requires careful risk assessment due to counterparty risks and lower liquidity. Regulatory authorities like SEBI and RBI continue to improve transparency and investor protection in OTC markets, ensuring safer trading environments in India.

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