Today while writing today`s blog, I was again confused as what to write with which may be of great use for my readers and finally decided to discuss a very basic topic of capital market which is The Difference between Exchange trading & Over-The-Counter trading (OTC Trading).
Many financial markets around the world, such as stock markets, do their trading through exchange. However, forex trading does not operate on an exchange basis, but trades as ‘Over-The-Counter’ markets (OTC). The stocks, bonds and other instruments traded on these exchanges are known as listed securities. Over the counter, or OTC, traded securities encompass all other financial securities. Understanding the differences between listed and an OTC transaction is crucial whether you want to trade shares or sell your firm’s shares to investors.
Difference Between Exchange Trading & OTC Trading:
- Centralization Of Market:In a market that operates with exchange trading, transactions are completed through a centralized source. In other words, one party acts as the mediator connecting buyers and sellers. There is a specified number of traders that will trade on that single centralized system. On the other hand, over-the counter markets are generally decentralized. Here, there are many mediators who compete to link buyers to sellers. The advantage to this is that it ensures that costs for intermediary services are as low as possible.
- Standardization: An Exchange Trade is a standard contract wherein Stock exchange acts as a guarantor for all the trades. But, OTC contracts are customized as there is no specified guarantor and hence the risk increases a lot.
- Counterparty Risk: When you buy or sell something OTC in a private transaction, there is always the risk of not getting what you bargained for. The other party might not be able to deliver the stock, bond or other security within the agreed upon time frame. It might also deliver a different kind of stock or bond than promised. These risks are broadly referred to as counterparty risk. In an exchange, however, counterpart risk is not an issue. The trading occurs through brokers who are closely monitored by both the exchange and the Securities and Exchange Commission. Investors buy exchange traded securities with greater confidence and therefore pay more for such stocks. Because of this, businesses are better off selling shares through an exchange rather than in a private transaction.
- Visibility: As Exchange market is an open market wherein there is a clear visibility for prices, start date, expiration dates & counterparties involved in a deal etc. But, this is not the case with OTC market as all the terms & conditions associated with any deal is between the counterparties only.
- Parties Involved: In exchange traded markets, the exchange is the counterparty to all of the trades. Additionally, there is price standardization and execution. One negative these exchanges involves less price competition. OTC, or over the counter markets, have no centralized trading facility. This promotes heavy competition between counterparties and lower transaction costs. The lack of regulation can introduce fraudulent firms and transaction execution quality may decrease.
In exchange markets, there’s a regulator (exchange) through which transactions are completed, while in OTC markets there is no regulator.
Exchange markets have less chances of price manipulation, while the many competing traders in OTC markets can manipulate prices.
Exchange markets ensure transaction security, while OTC markets are prone to fraud and dishonest traders.