On OTC Markets, Lowering the Bar for Regulation Lowers Market Quality

One of 2016’s highest-performing securities has been stock in a company that few investors had ever heard of a year ago. The stock had historically experienced little trading activity, and the company last reported financial results in 2013, when it had fewer than $5,000 in assets. But none of that kept shares in Neuromama Ltd. from more than quadrupling in value over the course of eight months, giving the company a market capitalization of $35 billion at its peak. It’s the latest case of an over-the-counter (or OTC) stock becoming the surprise beneficiary of mysterious—and, perhaps, suspicious—activity on the markets on which they’re traded.

Despite the unsavory image engendered by cases such as Neuromama, OTC markets are more regulated than their reputations may suggest. Often, though, their rules are not set by the US Securities and Exchange Commission (SEC)—in fact, the relevant regulatory regime varies from market to market, creating substantial disparities in the level of transparency required of publicly traded companies and the risks faced by investors. In a study of OTC markets and the stocks traded on them, Humboldt University’s Ulf Brüggemann, University of Alberta’s Aditya Kaul, Chicago Booth’s Christian Leuz, and Ohio State’s Ingrid M. Werner describe the landscape of OTC markets as a “twilight zone” of assorted regulatory regimes.

The researchers examined more than 10,000 domestic firms traded on OTC markets from 2001 to 2010, the regulatory structures surrounding those markets, and the ensuing “market quality” of various OTC markets. They focus on two important aspects of market quality that are closely related to the core objectives of securities regulators: market liquidity (how active trading is in a particular market) and crash risk (the likelihood that a stock’s price will lose almost all its value).

The three main markets for trading OTC stocks are the OTC Bulletin Board (OTCBB), Pink Sheets (operated by the OTC Markets Group), and the Grey Market. Companies traded on the OTCBB have, since 1999, been required to file regular reports to the SEC. Some companies traded on the Pink Sheets and in the Grey Market have to file with the SEC as well, but many have too few so-called record holders (an arcane way of counting shareholders) and therefore are exempt from SEC reporting. (Formerly, companies had to file reports to the SEC if they had more than 500 shareholders of record; under the JOBS Act of 2012, that threshold was raised to 2,000 shareholders, enlarging the number of companies that are exempt from SEC reporting.)

In most states, those firms not filing with the SEC must go through state merit reviews, and must be registered in each state if their stocks are to be traded there. But since most OTC companies are small—the average company in the study had a market capitalization of $52 million—this can be financially cumbersome. So in 41 states plus the District of Columbia, OTC firms are allowed to trade if they are covered or published in a nationally recognized securities manual, which performs a basic review of company history, financial statements, and other documents.

OTC stocks are highly volatile and often experience negative returns. In fact, the median annualized (log) return for an OTC stock during the 2001–10 study period is -46 percent. Hence, while less regulation helps smaller companies access capital markets, it also allows riskier companies to access those markets as well.

“We show that OTC firms that file disclosures with the SEC, publish information in a recognized securities manual, are headquartered in states with stricter merit reviews, and are in higher-level Pink Sheets information tiers exhibit higher market liquidity and lower crash risk,” the researchers write.

While the authors caution that their results show associations rather than causation, they note that while lowering regulatory requirements may ease burdens for small firms, it also “significantly reduces market liquidity and increases crash risk for investors.” The findings suggest that regulators face a crucial tradeoff between creating opportunities for small businesses to acquire capital and providing adequate protection to investors.

Though OTC stocks are hardly uniform in their regulatory burdens, the researchers did find one thing the vast majority of OTC firms had in common: a low probability of ever trading on a more traditional exchange. They find that only 17 percent of the firms in their sample were “fallen angels” that delisted from traditional exchanges such as the New York Stock Exchange. And though the sample also contained more than 3,000 “new” firms that entered the OTC markets during the study period without having publicly traded elsewhere before, fewer than 9 percent of these new firms ever moved up to the larger exchanges, suggesting that the vast majority of companies don’t use the OTC markets as stepping stones to more conventional trading venues.

The research described in this article is part of the Initiative on Global Markets' working papers series.