An Over-the-Counter (OTC) Stocks Primer
Over-the-counter stocks (OTC stocks) are those that are not traded on a centralized exchange like the NYSE or AMEX, but rather on electronic dealer networks like the Nasdaq or PinkSheets. Companies generally list on these exchanges in order to lower their regulatory costs while retaining access to the capital markets. The downside is that these markets typically experience less liquidity and appeal.
Most OTC stocks consist of smaller companies that are working their way up to a national listing on a centralized exchange or larger companies that have fallen and been delisted, known as fallen angel stocks. Others are simply larger companies that wish to avoid the sometimes-expensive regulatory requirements of listing on larger exchanges, such as Sarbanes-Oxley requirements.
OTC-BB and PinkSheets
The two largest OTC stock exchanges are the Nasdaq OTC Bulletin Board and the PinkSheets. Combined, these two OTC exchanges account for the majority of over-the-counter trading that takes place in the world markets.
The Nasdaq OTC-BB
The OTC-BB began in June 1990 on a pilot basis as part of important market structure reforms to provide greater transparency to the OTC stock market. The Penny Stock Reform Act of 1990 mandated that the Securities and Exchange Commission (SEC) establish an electronic system that met the requirements of Section 17B of the Exchange Act. Eventually, this materialized in the Automated Confirmation Transaction Service.
The OTC stock exchange was officially approved by the SEC in 1997 on a permanent basis with some modifications. Now, the OTC stock exchange provides access to more than 3,300 securities with more than 230 participating market makers. The exchange also features real-time quote, price and volume information for domestic and foreign securities as well as prior day trading activity.
The PinkSheets & OTCQX
Pink OTC Markets Inc. evolved from a paper-based publisher of “pink sheets” to one of the most advanced inter-dealer electronic quotation and trading systems in the OTC stock market. Their platform has efficiently connected market participants, improved price discovery, increased issuer disclosure, and better inform investors in OTC stocks.
PinkSheets now serves more than 230 financial services firms, including the ten largest U.S. investment banks. In 2007, these firms traded more than $160 billion in PinkSheet and OTCQX securities, which has made it one of the largest OTC stock exchanges in the global marketplace. Recently, PinkSheets launched its OTCQX exchange to provide a middle ground before eventual listing on a centralized exchange.
OTC Stock Fraud
The lack of regulatory requirements makes the OTC market a hot bed for fraudulent activity. In fact, one Business Week article estimated that chop stocks alone “make up perhaps half the 85 million-share daily volume of the OTC Bulletin Board”. As a result, the SEC has setup a guide to trading penny stocks that is available on its web site.
The most popular type of fraud among OTC stocks is a so-called “pump and dump” scheme, which involves the creation of biased recommendation that causes unwitting investors to purchase the stock and drive the price up. Once the price is elevated, the perpetrators of the fraud sell shares at the peak and stop hyping the stock to allow it to fall. The price then plummets and investors end up losing their money at the expense of the fraud perpetrators.
A second and growing type of fraud involves so-called “chop stocks” schemes in which a brokerage will purchase a large block of cheap, illiquid OTC stocks and sell them at large bid/ask spreads to unknowing investors. Since the brokerage is technically taking on a risk by holding the block, the government sees the spread as necessary, and the practice is not yet illegal.
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