Trading Chinese Assets… Over-The-Counter (OTC)?

As mentioned in previous articles, it is becoming easier and easier for the average investor to gain exposure to Chinese assets. In the US for example, there are even over 100 Chinese companies listed on Nasdaq and while things aren’t necessarily as straightforward in other jurisdictions, let’s just say impressive progress is being made across the board, in line with the increasing willingness (both endogenous and negotiated) of Beijing to facilitate foreign ownership of Chinese assets.

However, it is worth noting that in order for an asset to be listed on a formal exchange such as the New York Stock Exchange or the previously mentioned Nasdaq, certain conditions need to be met, in some cases remarkably strict ones. As such, not all businesses “qualify” and in order for them to gain market access, solutions such as Over-The-Counter or OTC trading have been found, with even some of today’s giants such as Walmart having started out by being traded via OTC platforms.

From simple stocks to ultra-complex derivatives, a wide range of assets can be traded OTC, with the main difference being represented by the fact that the two parties (the buyer and the seller) transact directly rather than the trade having to be cleared through formal exchanges such as, again, the NYSE or Nasdaq.

With this difference come a wide range of pros as well as cons.

Let us start with the latter (cons) in light of the fact that there is an overall perception of “sketchiness” when it comes to Over-The-Counter trading:

1. The fact that the other party can simply default or, to put it differently, greater counterparty risk than with other options. Let’s assume a US trader reached an agreement with a Chinese factory to buy a quantity of X identical products at an agreed-upon date, with counterparty risk pertaining to one of the parties defaulting at one point or another, either the US trader not paying or the factory reneging on its commitment
2. The fact that the Over-The-Counter space tends to be considerably more opaque compared to trading through formal exchanges, with it not even being necessary to disclose prices publicly. As such, there are always risks such as let’s say broker-dealers (the entities through which transactions are handled) offering “less stellar” deals to beginners compared to those in the proverbial know
3. The fact that the assets being offered aren’t always the epitome of legitimacy. While many people associate the Over-The-Counter space with more or less questionable penny stocks, it is worth noting that there are quite a few legitimate offerings out there. And, even more so, while the entities which facilitate transactions in the OTC space are less regulated compared to formal exchanges, some of them have relatively strict policies in place when it comes to the assets they allow, to the point of assets such as penny stocks not qualifying. Other broker-dealers less so and, again, it… well, depends
4. The fact that liquidity problems are far more common compared to formal exchanges, with those involved in the OTC space as traders knowing all too well that there are a fair share of instances in which sub-optimal liquidity forces them to either decide against selling until the situation improves or sell but accept a lower price than the one they had in mind (lowering the ask price enough so as to meet those on the bid price side of the fence)

However, there is no need to be excessively gloomy, with there being pros involved as well, for example:

1. Traders having access to (in our case Chinese) assets that are very tempting from a risk to reward perspective but which aren’t available through formal exchanges due to eligibility constraints. At the risk of sounding like a broken record, even Walmart started out in this space and on the opposite end of the spectrum, there are even individuals who earn a living by trading penny stocks
2. Being able to fly under the radar when making purchases, in other words actually making “con” #2 work in your favor
3. Having more wiggle room in light of there being considerably less legislative hurdles to overcome

… and so on.

Again, think of Over-The-Counter trading as yet another tool in your arsenal, a tool that can prove to be vital in your quest toward building a solid portfolio of Chinese assets or just a solid portfolio, broadly speaking. As long as you understand the particularities associated with buying and selling Chinese assets Over-The-Counter, you will be able to put together a risk assessment strategy that enables you to easily navigate waters others consider far too murky.

Does Over-The-Counter trading at least partially “deserve” its sometimes less than impressive reputation?

Probably.

But as someone who is interested in gaining exposure to Chinese assets in particular or more generally speaking, to assets the average Western investor oftentimes considers too exotic, keeping an open mind is a must. As such, just as keeping your mind open to possibilities associated with investing in “all things China” enables you to generate potentially career-altering returns in a jurisdiction many avoid due to an overly conservative to the point of unrealistically conservative risk management strategy, keeping your eyes and mind open to opportunities in the OTC space can enable you to do the same: generate impressive returns as a result of being open-minded enough to explore a space others steer clear from.

The ChinaFund.com team cannot stress this enough: few things are set in stone in the world of investing. While there is nothing wrong with adopting an ultra-conservative investment strategy, we firmly believe it represents a sub-optimal approach and if you and/or your organization are of the same opinion, the ChinaFund.com team is at your disposal when it comes to helping you put together a risk management strategy that actually makes sense.