The Twilight Zone: OTC Regulatory Regimes and Market Quality

Abstract

We analyze a comprehensive sample of more than 10,000 U.S. OTC stocks. We provide much needed descriptive evidence on this market and show that the OTC market is a large, diverse, and dynamic trading environment with a rich set of regulatory and disclosure regimes, comprising venue rules and state laws beyond SEC regulation. We also exploit the institutional richness of the OTC market and analyze two key dimensions of market quality, liquidity and crash risk, across firms and regulatory regimes. We find that OTC firms that are subject to stricter regulatory regimes and disclosure requirements have higher market quality (higher liquidity and lower crash risk). Our analysis points to an important trade-off in regulating the OTC market and protecting investors: Lowering regulatory requirements (e.g., for disclosure) reduces the compliance burden for smaller firms, but also reduces market quality.

Private Intermediary Innovation and Market Liquidity: Evidence from the Pink Sheets® Market

“… This is also consistent with Bruggemann et al. 's () finding that over time the Pink Sheets ® market quality has improved and even sometimes exceeds that of the OTCBB . …”

“…Also related to our study, Bruggemann, Kaul, Leuz, and Werner () use proprietary data to provide descriptive evidence on over 10,000 U.S. firms that trade in the OTC market during the period 2001–2010. They find that OTC firms with better disclosures generally have higher liquidity and price efficiency.…”

“…We do not favor this alternative because we believe that prior to the release of the disclosure tiers it was a fairly low‐cost endeavor to assess disclosure levels. There is also ample evidence (much of which we cite in this paper) suggesting that individual investors are not fully rational and the setting we examine includes primarily individual investors who “may be less sophisticated” (Bruggemann, Kaul, Leuz, and Werner , 8). Furthermore, although we argue that the disclosure tiers likely draw more investor attention to disclosure practices, we are not suggesting that this will lead investors to analyze more financial statements.…”

“… Share turnover is another liquidity measure that prior research often uses (Bushee and Leuz ; Pownall, Vulcheva, and Wang ; Bruggemann et al. ). We do not use this measure because data on firms’ shares outstanding are not readily available for our sample period, although OTCMG's current website reports firms’ shares outstanding. …”

Does Consumer Protection Enhance Disclosure Credibility in Reward Crowdfunding?

“…Costly disclosure requirements, however, may impose an excessive burden on small firms, which are usually the most innovative and high-growth ventures. Therefore, market regulators are confronted with a choice between: (i) a lightly-regulated market, capable of attracting small and innovative firms that can enjoy low disclosure burdens; and (ii) a heavily-regulated market, in which small high-growth firms may be discouraged by disproportionate compliance requirements (Brüggemann et al, 2017).…”