OTC vs Exchange

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). We’ll examine some differences between exchange trading and over-the counter markets in this article.

Differences
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. This situation places great power on the mediator, and this is a key disadvantage to this type of trading. The positive aspect to this is that it allows for better transaction enforcement, and stricter security. The NYSE is a typical example of an exchange traded market. In such a market, products could be standardized, and it could also be guaranteed that goods and products are in compliance with the terms of trade.

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. The obvious downside is that these markets are usually not regulated, and more prone to untrustworthy and fraudulent mediators. Examples of OTC markets include forex trading markets, as well as markets for buying and selling debt. Over-the-counter markets have overtaken exchange markets in terms of volumes traded daily, mainly due to the increase in electronic trading and the rise in alternative investing.

The differences also demonstrate that there is more counter party risk in over-the-counter traded markets than in exchange traded ones, because the ‘exchange’ acts as the regulatory, and is a counter-part to each transaction thus ensuring the delivery of funds or securities.

Also, exchange traded markets have less chances of price manipulation by mediators, since trading is on a centralized system. However, in OTC markets, it will largely be determined by how many dealers are trading in a particular security at a given time.

And since there are fewer clients willing to trade in OTC markets, the result will be less liquidity, whereas exchange traded markets tend to have many participants and clients, thus, there’s a generally higher level of liquidity.

Summary:
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.

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