The Hidden Side of Trading: Exploring India’s OTC and Unlisted Markets

Introduction:

When we think of stock trading in India, names like NSE and BSE instantly come to mind. These are the mainstream platforms where listed securities are bought and sold. However, beyond these well-known exchanges lies a parallel universe of trading—less visible, but equally dynamic—known as the Over-the-Counter (OTC) market.

OTC trading involves buying and selling financial instruments directly between two parties, without the oversight of a centralized exchange. It plays a crucial role in India’s financial ecosystem by offering access to unlisted shares, debt instruments, and pre-IPO securities that are otherwise unavailable on formal exchanges. For many seasoned investors, this hidden segment offers both lucrative opportunities and unique challenges.

In this article, we will take a deep dive into the structure of OTC markets in India, the types of securities traded, regulatory considerations, and what every investor should know before stepping into this lesser-known yet increasingly relevant part of the capital market.

What is OTC (Over-the-Counter)?

OTC, or Over-the-Counter, refers to a decentralized market where financial securities are traded directly between two parties—outside of a formal exchange like NSE or BSE. These trades are usually facilitated by brokers, dealers, or online platforms, without the prices being publicly disclosed on a central platform.

Unlike listed securities that trade on stock exchanges under strict regulations and transparency, OTC markets operate with less regulatory oversight, offering flexibility—but also carrying more risk.

The Objective of OTC Options

OTC options are primarily used by investors, hedgers, and speculators who seek flexibility beyond the limitations of exchange-traded options. These contracts are privately negotiated, allowing both parties to tailor terms such as strike prices, expiration dates, and contract size according to their specific needs—something that’s not possible with standardized market instruments.

This customisation helps participants manage unique financial risks or strategies more effectively and often more efficiently. However, since OTC trades bypass exchanges and clearinghouses, they come with greater counterparty risk and reduced transparency. The lack of regulatory oversight means both parties must rely heavily on trust and due diligence.

In essence, the objective of OTC options is to provide precision, privacy, and adaptability, making them a valuable tool for institutions and sophisticated investors—but one that requires careful handling.

Different Types of OTC Derivatives Based on Underlying Assets

Over-the-counter (OTC) trading encompasses a variety of financial instruments, with each type of derivative linked to a distinct class of underlying asset. Below are the key types of OTC derivatives:

1. Interest Rate Derivatives: These derivatives are based on traditional interest rates. One common example is interest rate swaps, where two parties exchange fixed and floating cash flows over time. These swaps allow participants to hedge against fluctuations in interest rates, making them valuable tools for financial institutions.

2. Commodity Derivatives: OTC trading also includes contracts tied to physical commodities like gold, oil, or agricultural products. Forward contracts in commodities are a typical example, where parties agree to buy or sell a commodity at a predetermined price at a future date, often used by producers and consumers to mitigate price risk.

3. Equity Derivatives: Equity derivatives are based on stocks or stock indices. Common OTC instruments in this category include stock options and equity futures, which enable investors to speculate on or hedge against price movements in specific stocks or broader equity markets.

4. Forex Derivatives: These derivatives are linked to foreign exchange rates. Forex derivatives, such as forward contracts and currency swaps, allow traders to manage or speculate on changes in the exchange rates between two currencies, helping businesses mitigate currency risk.

5. Fixed Income Derivatives: In this category, the underlying assets are fixed income securities, like bonds. OTC derivatives in the fixed-income market can include interest rate swaps or bond options, which help investors manage risks related to interest rate movements or bond price fluctuations.

6. Credit Derivatives: Credit derivatives enable one party to transfer the risk of credit events (such as defaults) to another. The two main types are funded and unfunded credit derivatives. Well-known examples include Credit Default Swaps (CDS) and Credit Linked Notes (CLNs), which allow investors to manage credit exposure without directly exchanging the underlying securities.

Advantages and Disadvantages of OTC Derivatives

Here’s a comparison table outlining the advantages and disadvantages of OTC (Over-the-Counter) derivatives:

Aspect	Advantages	Disadvantages
Customisation	Highly flexible and tailored contracts to meet specific needs of the parties involved.	Customisation can lead to complexity and potential for mispricing or misunderstanding of terms.
Privacy and Confidentiality	Transactions are private, which is ideal for large institutional players or those who wish to keep their positions confidential.	Lack of transparency makes it difficult for outsiders to assess market exposure or fair pricing.
Access to Unlisted Assets	OTC markets allow trading of assets that are not listed on exchanges, such as commodities, unlisted equities, or exotic financial products.	OTC markets are less regulated, which may expose traders to risks not found in exchange-traded products.
Counterparty Risk	Flexibility in negotiating counterparty terms based on trust or existing business relationships.	Higher counterparty risk as there’s no clearinghouse or central authority to guarantee the transaction.
Cost Efficiency	May be more cost-effective for large transactions due to fewer intermediary fees compared to exchange-traded derivatives.	Risk of higher costs if the counterparty defaults or if proper risk management measures are not in place.
Regulation and Oversight	Fewer regulations may benefit sophisticated participants who prefer a less structured environment.	The absence of a regulatory body or clearinghouse makes the OTC market prone to risks like fraud and default.
Liquidity	Suitable for large-scale trades, as parties can structure deals to match liquidity requirements.	Lack of a central marketplace can result in lower liquidity, making it harder to exit a position quickly.

Is OTC Trading Safe?

While OTC trading can be a valuable tool for certain investors, it is not without its risks. The lack of transparency, counterparty risk, and regulatory oversight can make OTC trading riskier than exchange-based trading. However, with proper risk management strategies, such as due diligence, collateral requirements, and legal safeguards, participants can reduce these risks and engage in OTC markets safely.

Investors looking to enter the OTC market should have a clear understanding of the instruments they are trading, the counterparty they are dealing with, and the specific terms of the contract. For those unfamiliar with OTC trading, it is advisable to consult with financial advisors or experts in the field before engaging in such transactions.

In conclusion, OTC trading offers flexibility and access to non-listed assets, making it an attractive option for sophisticated investors. However, it is crucial to recognise the risks involved—such as counterparty risk, lack of transparency, and potential regulatory gaps. 

For investors willing to manage these risks effectively, OTC trading can be a valuable addition to their portfolio. However, for those new to the concept, careful consideration and expert guidance are recommended to understand this complex market.

Disclaimer Note: The securities quoted, if any, are for illustration only and are not recommendatory. This article is for education purposes only and shall not be considered as a recommendation or investment advice by Equentis – Research & Ranking. We will not be liable for any losses that may occur. Investments in the securities market are subject to market risks. Read all the related documents carefully before investing. Registration granted by SEBI, membership of BASL & the certification from NISM in no way guarantee the performance of the intermediary or provide any assurance of returns to investors.

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