What is OTC Trading and how does it work? What you need to know in 3 minutes
I've been asked a number of times over the last few years what it's like to trade obscure financial products. How does one actually trade these things and what's the process? How are these things traded in tough markets?
This post is my small attempt at de-mystifying the world of OTC Trading, and I hope that folks find this helpful. This piece assumes some basic financial knowledge.
TL;DR - OTC trading is when you trade directly with someone else, like calling or messaging them, the old school way. A bunch of financial stuff (still!) trades this way. The good? You can do all kinds of custom trades to express unique investment ideas. The bad? The market of active participants is often small, liquidity (the ability to buy/sell) can evaporate in a flash, and bid/offer spreads can be wide.
Usually, trading things like stocks, options, commodities or FX is pretty easy. You open your app/program, click a few buttons, buy/sell and get on with your day. But, there is a bunch of stuff (bonds, loans, derivatives and other things) that trades OTC. Those crazy trades that you see on TV/The Big Short where some investor bet on the end of the world? Probably traded OTC.
What is OTC Trading?
When you buy stock, you do so through your broker. You push a few buttons, and the order gets sent to your broker, which then goes to an exchange. Your order gets executed when your buy order is matched with a seller’s order.12
OTC stands for “over the counter.” This is when stuff is not traded on an exchange, like described above. You contact a broker (usually a bank) directly, ask for a price and then buy/sell. You’ve seen those old movies, where a bunch of dudes are sitting in a room and yelling on the phone? That’s OTC Trading.
So how does the broker make money?
Brokers change a spread. For example, you call/message your broker. Usually, people use Bloomberg’s instant messenger system, called “IB Chat”. Every quote has a bid (the price at which the broker would buy) and an offer (the price at which the broker would sell). The difference between the bid and the offer is called the spread, and that’s what the broker takes.
Wait a second. What’s Bloomberg IB Chat?
You remember AIM/MSN Messenger? Same thing. It’s how lots of people in the financial world talk and trade. Sounds kinda 1998-ish? You bet. Don’t remember AIM/MSN because you’re too young? Google it.
Ok, what does an actual OTC Trade dialogue look like?
A typical, simple IB chat could look like this:
Hedge Fund Guy: Good morning, where are you in Tesla 2022 bonds, please?
Broker: One sec… 100/1013
Hedge Fund Guy: buy $10 million
Broker: You buy $10 million Tesla 2022 bonds at 101. Thank you for the trade.
It’s that simple?
It can be. But remember, there is more than one broker out there, and if you want to maximize profits, you’ll ask other brokers for a price. Think about shopping around for gas for your car. Usually, you go to the cheapest place, assuming they are equally convenient, right? I mean, gas is gas. Bonds are bonds. All else equal, what difference does it make if you buy bonds from Citigroup or Morgan Stanley?4
Anyhow, after you blast out a message to 15 brokers asking for a price, your screen will soon have flashes from a bunch of chat rooms. Like remember when you were on AIM/MSN and you were chatting with numerous people at the same time and every time you got a new message their name flashed in a bright color or whatever? Same thing. Your typical chat window may look like the below example. For like 20 chats.
Hedge Fund: Good morning, where are you in Tesla 2022 bonds, please?
Broker 1: 100/101
Broker 2: 100.1/100.9
Broker 3: 100.25/101.25
This sounds simple enough. Where does it get difficult?
It gets difficult when you want to trade and you can’t really do it. Due to regulations that were put in place following the Global Financial Crisis in 2008-2009, banks have been required to hold more cash and other things that they can buy/sell easily. This means that they are limited as to how many things like bonds or derivatives that they can hold, because that stuff isn’t necessarily bought or sold easily. This means that bank trading desks can be picky about what and how much they will trade. See below.
Hedge Fund Guy: Good morning, where are you in Tesla 2022 bonds, please?
Broker: 100/101
Hedge Fund Guy: buy $10 million
Broker: Uh… I can sell you $3 million Tesla 2022 bonds at 101 and try to find the rest of them?
Hedge Fund Guy: Ugh. Yes, fine.
Broker: You buy $3 million Tesla 2022 bonds at 101. Thank you for the trade.
Broker (5 minutes later): I found you $2 million of bonds from another client. I can sell them at 101.5!
Hedge Fund Guy (Sighs): Fine, yeah I’ll take those as well.
Broker: You buy $2 million Tesla 2022 bonds at 101.5. Thanks.
Hedge Fund Guy wanted $10 million of bonds. The broker made a price. Hedge Fund Guy bought. But the broker only had $3 million of bonds of inventory. He sold them to Hedge Fund Guy. Then the broker made some phone calls and blasted out a one-line message on IB Chat to his clients (other hedge funds, mutual funds, etc) saying that he had a buyer of Tesla 2022 bonds. And then, one client agreed to sell $2 million of bonds for 101. The broker went back to Hedge Fund Guy who agreed to buy the bonds for 101.5. The bank pocketed the 0.5 difference.
What sucks? Well, Hedge Fund Guy wanted to buy $10 million of bonds. But he wasn’t able to do so, and in the process of only getting half of the amount that he wanted, he also moved up the price. Blech.
This sounds lame, but whatever. Is there a way this can get really bad?
Sure. Think about a time, like March 2020 when the markets were brutal, and most investors were losing money. If you wanted to sell your stock, you could, right? Like maybe you had bought Tesla stock at $180 a share in February 2020 and then saw it fall to $90 in March and wanted to get out. You yelled a few obscenities, clicked a few buttons and sold.
Here’s the OTC version of may have happened.
Hedge Fund Guy: Hi. Tesla 2022 bonds, please.
Broker 1: Hi. Uhm, let me check. Uh, 70/80
Hedge Fund Guy: Didn’t we trade 3 days ago at 101 and it was 100/101, bid/offer?
Broker 1: Market’s changed, bro. You’ve seen the news.
Broker 2: We are offer only at 815
Hedge Fund Guy: Are you joking?
Broker 2: Sorry man.6
Broker 3: We aren’t active in that name7
Broker 4: 65/80
Hedge Fund Guy (to Broker 1): Ok, I sell $10m
Broker 1: Uhm, yeah, I can take $2 million bonds at 70.
Hedge Fund Guy (yelling and throwing something at the wall): Ok. Fine.
Broker 1: You sell $2 million Tesla 2022 bonds at 70. Thank you for the trade.
About 30 seconds later… Hedge Fund Guy’s screens flash
Broker 1: Tesla 2022 bonds 65/75
Broker 4: 60/75.
Hedge Fund Guy wanted to sell $10 million of bonds. However, Broker 1 was only willing to buy $2 million of those bonds because the market is falling, and he doesn’t want his team to lose money.8 Hedge Fund Guy still wants to sell another $8 million bonds and he’s taking a huge loss (he bought at 101 a few days earlier and he just sold some at 70, which is a huge move, especially in bonds).
Now the Hedge Fund Guy has a problem. The more he sells (and that’s assuming a bank will trade with him), the more the price goes down and the bigger the loss he takes. Now remember, Hedge Fund Guy isn’t the only investor that is trying to sell. There are other hedge funds, mutual funds, etc who are also selling. Each investor doesn’t just own Tesla 2022 bonds, maybe they own Apple Bonds, or whatever. On the other side, you have banks that don’t want to take the risk of owning these things without having a client on the other side willing to buy them, because this could mean losses for them.
What are the limitations of OTC Trading?
As you can see from the examples above, you are not interfacing with an open market with a lot of other investors; You are actively negotiating with some guy on the other side to trade. This means that the universe of buyers and sellers is probably smaller. It also means that if you want to buy/sell lots of stuff, doing it OTC means that you may not be anonymous. People talk. You are also limited to the bank’s inventory or the broker’s ability to convince someone else to take the other side of the trade.
Wait a second, does this mean that the market can be as small as like 50 – 100 dudes trading stuff?
Yes, or even smaller. Most people that actively trade a certain OTC product often know each other.
Sounds like OTC Trading can be super lame. What are the benefits, if any?
Trading OTC means that you can customize your trades (at a price…). For example, maybe you think that, uhm (I’m making this up), the toy industry in Germany is going to collapse. And to express that idea, you have (often with the help of a broker) decided to buy some kind of exotic financial derivative, or option, or whatever, that should benefit in case that happens, so that you can make a ton of money and be profiled in the next Michael Lewis book? Yeah, those are the trades that you do OTC.
Actually, it probably goes from your broker to big market-making firm, called a wholesaler. The wholesaler pays your broker for that order and then internally matches buy orders with sell orders. So that’s technically OTC, as well, but the trade could be done on the exchange as well! For more detail read Matt Levine’s piece here.
A bunch of things trade OTC. For example, one thing that is traded OTC, but seems like it’s on the exchange is spot FX, which is traded 24 hours/day. Spot FX is liquid (ie there are lots of big buyers and sellers at any time) and the trading interface can make you think that you are trading on an exchange like with stocks. But you aren’t.
Simply, there are two jobs on a bank trading floor. There is the trader and the salesperson (or broker). The broker interacts with the client, pitches ideas, and gives market color. The trader sets the prices and trades on the bank’s behalf. Usually when a client asks for a price, the broker turns to/shouts to the trader, asks for the price, gets it, and tells the client.
Actually, the difference can be big. Since some banks bring hot new deals (think like IPOs) that Hedge Fund Guy wants access to, because Hedge Fund Guy’s firm and the bank do a lot of business with other parts of the bank. There definitely exists a significant relationship angle in which brokers and hedge fund dudes try to look out for each other.
This means we won’t buy any from you but are happy to dump some of our supply (or that of a client) at 81.
We don’t want to buy that crap from you, lose the bank’s money and then get fired.
We want nothing to do with this bond right now. We don’t want to lose money and get fired either.
Broker 1 doesn’t want his team to lose money because that means he and his trader could get fired. At the same time, he wants to stay in Hedge Fund Guy’s good graces, because Hedge Fund Guy probably trades a lot with him and is a source of income. If they both survive the terrible market conditions (ie. don’t get fired), Hedge Fund Guy may not want to trade with Broker 1 when things get more stable. Broker 1 relies on clients like Hedge Fund Guy to trade with him to make his team (and therefore himself) money. As a result, Broker 1, tries to get his trader to make Hedge Fund Guy a price, hoping that Hedge Fund Guy will trade with someone else, or if Hedge Fund Guy sells to him, he will only buy a small bit and limit his team’s losses. It’s a tough act to balance.