Unlike exchanges, OTC markets have never been a “place.” They are less formal, although often well-organized, networks of trading relationships centered around one or more dealers. Dealers act as market makers by quoting prices at which they will sell (ask or offer) or buy (bid) to other dealers and to their clients or customers. That does not mean they quote the same prices to other dealers as they post to customers, and they do not necessarily quote the same prices to all customers. Moreover, dealers in an OTC security can withdraw from market-making at any time, which can cause liquidity to dry up, disrupting the ability of market participants to buy or sell. Exchanges are far more liquid because all buy and sell orders, as well as execution prices, are exposed to one another. Also, some exchanges designate certain participants as dedicated market makers and require them to maintain bid and ask quotes throughout the trading day. In short, OTC markets are less transparent and operate with fewer rules than do exchanges. All of the securities and derivatives involved in the financial turmoil that began with a 2007 breakdown in the U.S. mortgage market were traded in OTC markets.
OTC dealers convey their bid and ask quotes and negotiate execution prices over such venues as the telephone, mass e-mail messages, and, increasingly, instant messaging. The process is often enhanced through the use of electronic bulletin boards where dealers post their quotes. The process of negotiating by phone or electronic message, whether customer to dealer or dealer to dealer, is known as bilateral trading because only the two market participants directly observe the quotes or execution. Others in the market are not privy to the trade, although some brokered markets post-execution prices and the size of the trade after the fact. But not everyone has access to the broker screens and not everyone in the market can trade at that price. Although the bilateral negotiation process is sometimes automated, the trading arrangement is not considered an exchange because it is not open to all participants equally.
There are essentially two dimensions to OTC markets. In the customer market, bilateral trading occurs between dealers and their customers, such as individuals or hedge funds. Dealers often initiate contact with their customers through high-volume electronic messages called “dealer-runs” that list various securities and derivatives and the prices at which they are willing to buy or sell them. In the interdealer market, dealers quote prices to each other and can quickly lay off to other dealers some of the risks they incur in trading with customers, such as acquiring a bigger position than they want. Dealers can have direct phone lines to other dealers so that a trader can call up a dealer for a quote, hang up and call another dealer and then another, surveying several dealers in a few seconds. An investor can make multiple calls to the dealers with which they have established a trading relationship to get a view of the market on the customer's side. But customers cannot penetrate the market among dealers.