OTC 101 — Part 1 - Market Structure

 The OTC market provides an alternative to stock exchange listing for securities of issuers that either choose not to be listed on a U.S. stock exchange or do not meet the relevant listing requirements. The term ‘OTC securities’ is a catch–all phrase for any security that is not listed on a U.S. stock exchange.
OTC Market structure is very similar to other equity security markets. A key difference, however, is in the actual trading process, which will be explained in Part 2 – Trading. The five participants in the OTC market include:

• Companies
• Investors
• Broker-dealers
• Regulators
• Inter-dealer Quotation/Trading Systems (e.g., Pink OTC’s Pink Quote platform)

These participants each perform different functions and each has different constituents. Understanding how they work together and compete against each other to create a more efficient OTC marketplace will help make understanding more complex market concepts easier.

1. Companies (Issuers) – Companies create and sell securities in the market to raise capital, complete an acquisition and/or allow selling shareholders to exit their investments.
   Companies may issue and sell shares in the OTC market pursuant to the safe-harbor guidelines under SEC Rule 144 and 144A; however, new issuances among OTC companies is relatively rare.
   In the OTC market, companies that qualify and are current in their financial disclosure may choose to list currently tradeable security(ies) on OTCQX. Companies may also choose to provide adequate disclosure either to regulators or Pink OTC Markets in order to be classified in a ‘Current’ OTC Market Tier.
   Liquidity follows transparency. Companies that provide current disclosure either through a regulator or directly to Pink OTC Markets experience significantly greater levels of liquidity, improved price discovery, and more efficient trading.
   
2. Investors – Investors in the OTC market vary in their knowledge and experience from large institutional money managers to retail investors. The goal of all of these investors is the same – to generate returns from their investment. Pink OTC facilitates information transparency in the OTC market by aggregating and disseminating real-time broker-dealer quote information and operating the platform for companies to provide financial and other corporate disclosure for investors.
   All investors must execute their OTC securities transactions (buy and sell orders) through a FINRA-registered broker-dealer. Individual investors should check to see if their broker-dealer trades OTC securities. More information on trading is available in Part 2 – Trading.
   
3. Broker-Dealers – Broker-dealers (such as E*Trade, Knight Equity Markets, UBS, Citigroup) participate in the OTC market by executing client orders and principal orders. Broker-dealers earn revenues from commissions charged on orders, the bid (buy) and ask (sell) spread (the difference between what an investor is willing to buy and sell a security), and principal trading (investing the firm’s capital in an investment/trading strategy).
   Broker-dealers often receive buy and sell orders that ‘match’ – meaning, someone is willing to sell a security for the same price someone else is willing to buy the same security. In this situation, broker-dealers will execute the trade “internally”. This is preferable for broker-dealers because they receive commissions on both the buy and sell-side of the trade. In executing client orders, broker-dealers may also buy or sell for their own (principal) account, at their own risk. If, however, there is no match for a trade or a broker-dealer does not wish to trade for their own account then a broker-dealer must find another broker-dealer willing to trade that particular security.
   Regardless of the broker-dealer’s decision regarding a customer order, they must comply with FINRA’s ‘Best Execution’ Rule 2320. ‘Best Execution’ and other customer protection rules are discussed in more detail in Part 3 – Regulation.
   There is no central ‘exchange’ (e.g., NYSE) in the OTC market; therefore, broker-dealers must communicate and trade directly with other broker-dealers. In order to notify other broker-dealers that they are willing to trade a security at a particular price, broker-dealers post their ‘quotes’ on an Inter-dealer Quotation system such as Pink Quote or the OTC Bulletin Board. The aggregation and ranking of these quotes defines the ‘market’ for a security. The highest ‘bid’ (purchase price) and lowest ‘ask or offer’ (sale price) becomes the ‘inside market’ or NBBO – the National Best Bid and Offer.
   If a broker-dealer decides to trade they can communicate with other broker-dealer(s) using Pink Link – Pink OTC’s electronic messaging and trade negotiation system – or they may contact the broker-dealer over the phone and negotiate the trade.
   
4. Regulators – The OTC market and broker-dealers’ activities in the market are regulated by The Financial Industry Regulatory Authority (FINRA), the U.S. Securities and Exchange Commission (SEC) and various state securities regulators. As well, companies with SEC-registered securities are regulated by the SEC. Pink OTC Markets is neither a stock exchange nor a self-regulatory organization (SRO) and is not regulated by either FINRA or the SEC.
   Complaints regarding companies should be directed to the SEC, while complaints regarding broker-dealers or other investment professionals should be directed to FINRA. More information about specific OTC regulations is covered in Part 3 – Regulation.
   
5. Inter-dealer Quotation/Trading Systems – Inter-dealer Quotation/Trading Systems allow broker-dealers to post and disseminate their ‘quotes’ (prices) to the market place and, in the case of Pink Link, negotiate trades at agreed-upon prices. The two major Inter-dealer Quotation Systems are:
   • Pink Quote (operated by Pink OTC Markets)
   • OTC Bulletin Board (operated by FINRA)
   Pink Quote allows broker-dealers to quote any OTC equity security eligible for quoting under SEC Rule 15c2-11. Currently, there are over 9,000 securities quoted on the Pink Quote system. Broker-dealers access the Pink Quote system either through Pink OTC Markets’ OTC Dealer or Pink FIX applications. These applications allow broker-dealers to view all quotes for OTC securities and, if desired, trade those securities through Pink Link (which is accessible through OTC Dealer and Pink FIX ).
   The OTC Bulletin Board (OTCBB) system, on the other hand, is a quotation only system, as it lacks the electronic messaging capabilities of Pink Link. Furthermore, only companies that are SEC-reporting (or bank/insurance reporting) are eligible for quotation on the OTCBB. Since these securities may also be quoted on Pink Quote, many BB eligible securities are ‘Dually-Quoted’ on both inter-dealer quotation systems. Currently, there are approximately 3,400 securities that are quoted on the OTCBB, of which approximately 3,370 are also quoted on Pink Quote. Currently, there are 28 securities that are quoted on the Bulletin Board only.
   The significant majority of broker-dealers quote the securities of SEC-reporting companies on both systems because the OTCBB does not have electronic trading capability. Broker-dealers must use Pink OTC’s Pink Link system to trade these securities electronically.
   Pink Quote and the OTCBB distribute their market data to broker-dealers, investment professionals, market data re-distributors, and financial websites, including OTCMarkets.com.
   The real-time dissemination of quote information provides price transparency, which leads to a more efficient investment/trading process. The dissemination of price information and company financial data to the investment community (including individuals) leads to the development of new prices via trading decisions. This continuous flow of information between participants defines the OTC market and all market places.
   
   
   http://www.otcmarkets.com/learn/market-structure