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Over-The-Counter Trading and NASDAQ

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Securities not sold on an organized exchange like the NYSE are traded over-the-counter (OTC). A stock may not be listed on an organized exchange for several reasons, including lack of widespread investor interest, small issue size, or insufficient order flow. The OTC stock market is a dealer market. Since different OTC issues are not usually close substitutes for each other, a dealer with limited capital can make a profit with a relatively narrow range of stock inventory. As a result, there is a large number of small OTC dealers. They often concentrate their trading in particular industry groups or geographical areas. It is estimated that about 30,000 various types of equity securities are traded in the OTC market. However, only about 15,000 of these securities are actively traded.

When customers place a buy or sell order for a stock in the OTC market, a broker will contact other dealers who have that particular stock for sale and search out the best price. When satisfied, he or she will complete the buy or sell transaction with that dealer and charge his or her customer the same price plus a commission for the brokerage services.

A major development of the OTC market occurred in 1971 when the National Association of Securities Dealers (NASD) introduced an automatic computer-based quotation system, called NASDAQ. The system offers continuous bid-and-ask prices for the most actively traded OTC stocks. NASDAQ's development accelerated the disclosure of price information, and it also fundamentally altered the structure of the OTC market.

There are three levels of access to the NASDAQ system. Level 3 terminals are available only to dealers and allow them to enter bid and ask quotations for specific stocks into the system. These quotations, together with information identifying the stock and the dealer, appear within seconds on the terminals of other dealers and brokers. For this reason, the NASDAQ always has current prices. Level 2 terminals display all the dealer bid and ask quotations for a given stock, but do not allow that quotation to be changed on the terminal. These terminals are available to brokers and institutions. Level 1 terminals provide only the best bid and ask price (called the inside quote) for a stock. These terminals are used by stockbrokers when quoting prices to their customers.

This greatly increased the efficiency of a broker's search for the best bid-and-ask prices, reducing the amount of trading away from the best available prices.