What is the difference between exchanged traded markets and over the counter markets?

The terms exchange traded and over the counter markets (OTC) are used frequently in the financial world but what do they both mean?

Exchange traded market

In an exchange traded market, there is an intermediary which acts as centralized organization. They can link up buyers and sellers of a product. Contracts are be standardized and there are rules and regulations for trading. Exchange traded instruments are highly liquid so it makes it easier for investors to buy and sell their stocks. There is also less risk of counterparty default as the exchange acts as the intermediary and will take on the financial risks. Exchange traded instruments offer transparency as market prices can be viewed by all market participants.

There are two major stock exchanges in Australia:

The Australian Securities Exchange (ASX)

Chi-X Australia

OTC markets

An OTC market or over the counter market is where trades are executed via broker/dealers and there is no single exchange linking up the buyer and seller. In an OTC market there many dealers/intermediaries that link up the buyers and sellers. Trading on the OTC usually occurs electronically. There are fewer regulations with the OTC products compared to exchange traded products. Counterparty risk may pose as an issue with an OTC product as there is a risk that a party may default on payments. Liquidity may also be an issue with OTC markets as some products may not be traded frequently or have high demand. There is less transparency with OTC prices as traders can only see market marker quotes.

Lauren Hua is a private client adviser at Fairmont Equities.

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