In the minds of many investors, the over-the-counter market is like a neighborhood that is best avoided. Its dark corners are rife with shady stock promoters, boiler room brokers and pump-and-dump scammers.
But in at least one corner of the neighborhood, gentrification has set in. Trading in foreign securities on the U.S. OTC exchanges is flourishing, driven in large part by institutional investors. Based on mid-year data, OTC trading volume in American Depositary Receipts (ADRs) and foreign ordinary shares is on track to reach $160 billion this year, more than doubling over the five years since 2009, as U.S. investors have increased their portfolio allocation to non-U.S. securities.
The number of ADRs and foreign ordinaries on the OTC has increased nearly six-fold since 2003, reaching more than 3,600 as of June 30. Foreign companies trading on OTC markets include blue-chip names like Nestl, Heineken and Roche. Three-fourths of all ADRs in the U.S. trade on the OTC.
Why the growth? From the point of view of U.S. investors, ADRs offer advantages over buying shares directly in foreign markets. These advantages include liquidity and price transparency during U.S. trading hours,less expensivesettlement in U.S. dollars, and the ability to trade without managing foreign accounts.
Many large foreign companies would like better access to U.S. investors but are dissuaded by the regulatory burdens of listing on the NYSE or Nasdaq. Companies that chose not to submit to these rigors are still able to have their shares trade in the U.S. but they will trade over the counter either in the OTC Markets SEC-regulated Alternative Trading System (ATS) or in the grey market.
Market-maker OTC Market spreads are generally tighter than spreads in the grey market for both ADRs and foreign ordinaries because all market makers must have their pricing out-loud on the ATS, rather than disseminating quotes and prices only by customer request via phone or instant message.
The major challenge facing the OTC markets is that their reduced reporting requirements and abundance of sub-$1 shares continue to attract scam artists. The buyer beware nature of penny stock trading was illustrated this summer by the spectacular rise and fall of Cynk Technology (CYNK) which, as Businessweek put it, was a company with no assets, no revenue, and one employee, that for one hour in July had a market value of more than $6 billion.
The incident was unfortunate for the scammed investors, of course, but also for OTC Markets Group, which has been working hard to clean up the image of OTC trading.
In 2007, OTC Markets moved to strengthen market integrity by dividing shares into three submarkets according to the level of disclosure they provide. The OTCQX is labeled as the highest tier of companies offering the highest level of disclosure, followed by the OTCQB, and finally the OTC Pink. In August, OTC Markets stopped using its homepage to highlight activity, news releases and financial reports of companies trading on OTC Pink, instead only featuring companies on OTCQX and OTCQB. Our homepage is the front door to our website and we want to share it with companies that embody our values of being open, transparent and connected, OTC Group President and CEO R. Cromwell Coulson wrote in a July letter posted on OTCs website.
The three-tiered subsector model is a huge step in the right direction to strengthen market integrity via disclosure. However, there is still more that can be done to clarify the good from the bad. Why are blue chip companies like Nestle and Siemens left under the third tier OTC Pink designation? The answer is because they have not elected to upgrade to the QX or QB despite their eligibility. If a company relies on a market maker to choose to list their security OTC, why is it the companys responsibility to subscribe to their eligible tier? There must be a secondary designation to help differentiate blue chip from caveat emptor.
Mr. Coulson and his team have done a tremendous job illuminating the foreign market for U.S. broker dealers and investors. The responsibility is not only his to weed out the CYNKs of the world; we need help from our fellow market makers, our regulators, and the investing public. Louis Brandeis said that sunlight is the best disinfectant. I think we would all like to see a little more shine on what is truly a great marketplace.
Jacob H. Rappaport is managing director and head of Americas Trading at INTL FCStone Securities Inc., which makes markets in nearly 3,000 foreign securities and ADRs trading on the OTC markets.
