An over-the-counter (OTC) market does not use a centralized trading mechanism, such as an auction, specialist, or limit-order book, to aggregate bids and offers and to allocate trades. Instead, buyers and sellers negotiate terms privately, often in ignorance of the prices currently available from other potential counterparties and with limited knowledge of trades recently negotiated elsewhere in the market. OTC markets are thus said to be relatively opaque; investors are somewhat in the dark about the most attractive available terms and about whom to contact for attractive terms. Prices and allocations in OTC markets are to varying extents influenced by opaqueness and by the role of intermediating brokers and dealers. This chapter outlines some of the key institutional features of OTC markets that influence the formation of prices and allocations. Many details are omitted.
Some of the key research and policy issues regarding OTC markets include: (i) criteria that determine whether a financial product trades in an OTC market or on an exchange, (ii) the manner in which the price negotiated on a particular trade reflects the relative degrees of connectedness of the buyer and seller with the rest of the market, (iii) the formation and behavior of dealer franchises and oligopolies as well as interdealer brokers, (iv) the influence of market structure on the cross-sectional dispersion of prices negotiated at a particular time and on the time signature of price reactions to supply or information shocks, (v) the evolution over time of the distribution across investors of information learned from private trade negotiations, (vi) the effect of pre-trade and post-trade price transparency on market behavior, (vii) the impact of counterparty credit risk on pricing and financial stability, and (vii) the equilibrium strategies chosen by investors regarding their search for counterparties. Some of these issues form the main subject matter of this book. Others are left open for future research.