Look at the primary and secondary markets

The word “market” can have many different meanings, but it is most often used as an all-encompassing term to denote primary and secondary markets. In fact, “primary market” and “secondary market” are two different terms; the primary market refers to the market in which securities are created, while the secondary market is the market in which transactions are conducted between investors.

Understanding how the primary and secondary markets work is key to understanding how stocks, bonds, and other securities trade. Without them, capital markets would be harder to navigate and profits would be much lower. We’ll help you understand how these markets work and how they relate to individual investors.

key takeaways

  • The primary market is where securities are created, and the secondary market is where investors trade those securities.
  • In the primary market, companies sell new stocks and bonds to the public for the first time, such as an initial public offering (IPO).
  • The secondary market is basically the stock market and refers to the New York Stock Exchange, Nasdaq and other exchanges around the world.

primary market

The primary market is where securities are created. It is in this market that companies first sell (circulate) new stocks and bonds to the public. An initial public offering (IPO) is an example of a primary market. These transactions provide investors with the opportunity to purchase securities from banks that initially underwrite a particular stock. An IPO occurs when a private company first issues stock to the public.

For example, ABCWXYZ Inc. hired five underwriters to determine the financial details of its IPO. The underwriters specified that the shares would be offered at $15. Investors can then buy the IPO directly from the issuing company at that price.

This is the first opportunity that investors have to inject capital into the company by buying shares of the company. A company’s share capital consists of funds generated from the sale of shares in the primary market.

Types of main products

A rights issue (issue) allows a company to raise additional equity through the primary market after it already has securities in the secondary market. Current investors receive pro-rata rights based on the shares they currently own, and others can reinvest in newly issued shares.

Other types of primary market offerings of shares include private placements and rights issues. Private placements allow companies to sell shares directly to more important investors, such as hedge funds and banks, without disclosing the shares. While rights issues offer shares to specific investors (usually hedge funds, banks, and mutual funds) at special prices that are not available to the public.

Likewise, corporations and governments that want to generate debt capital can choose to issue new short- and long-term bonds in the primary market. The coupon rate of the new bond corresponds to the current interest rate at the time of issuance and may be higher or lower than the existing bond.

An important thing to understand about the primary market is that securities are purchased directly from the issuer.

Secondary market

For buying stocks, the secondary market is often referred to as the “stock market.” This includes the New York Stock Exchange (NYSE), Nasdaq and all major exchanges around the world. The defining characteristic of secondary markets is transactions between investors.

That is, in the secondary market, investors trade previously issued securities without the participation of the issuing company. For example, if you buy Amazon (AMZN) stock, you’re just dealing with another investor who owns Amazon stock. Amazon was not directly involved in the deal.

In the debt market, while a bond is guaranteed to pay its owner the full face value when it matures, that date is usually many years later. Conversely, if interest rates fall after a bond is issued, bondholders can sell the bond for a handsome profit in the secondary market, making it more valuable to other investors due to its relatively high coupon rate.

The secondary market can be further subdivided into two specialized categories:

auction market

In an auction market, all individuals and institutions who want to trade securities gather in one area and announce the price at which they are willing to buy or sell. These are called bid and ask prices. The idea is that an efficient market should prevail by bringing all parties together and letting them publicly announce their prices.

Therefore, in theory, there is no need to search for the best price for an item, because the convergence of buyers and sellers will result in a mutually agreed price. The best example of an auction market is the New York Stock Exchange (NYSE).

dealer market

In contrast, the dealer market does not require all parties to come together in a central location. Instead, market participants are joined through an electronic network. A dealer holds an inventory of securities and is then ready to buy or sell with market participants. These traders make profits from the spread between the prices at which they buy and sell securities.

An example of a dealer’s market is the Nasdaq, where dealers known as market makers provide established bid and ask prices for securities they are willing to buy and sell. The theory is that competition among dealers will provide investors with the best possible price.

The so-called “third” and “fourth” markets involve transactions between broker-dealers and institutions over an over-the-counter electronic network and are therefore not relevant to individual investors.

OTC market

Sometimes you’ll hear a dealer market called an over-the-counter (OTC) market. The term originally referred to a relatively disorganized system in which transactions took place not in physical locations, as described above, but through a network of dealers. The term likely originated from the non-Wall Street trading that flourished during the great bull market of the 1920s, in which stocks were sold “over the counter” in stock shops. In other words, these stocks are not listed on the stock exchange, they are “unlisted”.

Over time, however, the meaning of OTC began to change. Nasdaq was created in 1971 by the National Association of Securities Dealers (NASD) to bring liquidity to companies that trade through a network of dealers. At the time, there were few regulations on over-the-counter stocks, something the NASD was trying to improve. As Nasdaq has grown into a major exchange over time, the meaning of over-the-counter trading has become more obscure.

Today, the term “over-the-counter” usually refers to stocks that are not traded on stock exchanges such as the Nasdaq, the New York Stock Exchange, or the American Stock Exchange (AMEX). This means that the stock is traded on the over-the-counter bulletin board (OTCBB) or pink sheet. None of these networks are exchanges; in fact, they describe themselves as providers of securities pricing information. OTCBB and Pink Sheet companies have far fewer regulations to follow than companies that trade their shares on stock exchanges. Most securities traded in this way are penny stocks or from very small companies.

For these reasons, while Nasdaq is still considered a dealer’s market and is technically an over-the-counter market, Nasdaq today is also a stock exchange, so saying it trades unlisted securities is not precise.

$25.5 trillion

Market capitalization of the world’s largest stock exchange, the New York Stock Exchange, as of March 2020.Stock exchanges are considered part of the “secondary” market.

3rd and 4th market

You may also hear the terms “third” and “fourth” markets. These are irrelevant to individual investors as they involve a large number of stocks to be traded per trade. These markets process trades between broker-dealers and large institutions through an electronic network of over-the-counter transactions.

The third market includes over-the-counter transactions between broker-dealers and large institutions. The fourth market consists of transactions between large institutions.

The main reason these third and fourth market transactions occur is to avoid placing orders through major exchanges, which can greatly affect the price of a security. With limited access to the third and fourth markets, their activities have little impact on the average investor.

bottom line

While none of the activity that occurs in the markets we discuss affects individual investors, it is good to have a general understanding of the market structure. The way securities enter the market and are traded on various exchanges is central to the functioning of the market. Imagine if there were no organized secondary markets; you would have to personally track down other investors to buy and sell stocks, which is no easy task.

In fact, many investment scams revolve around securities with no secondary market, as unsuspecting investors can be tricked into buying them. The importance of the market and the ability to sell securities (liquidity) is often taken for granted, but without the market, investors have few options and can be caught in huge losses. So when it comes to the market, things you don’t know can hurt you, and a little education might just save you some money in the long run.

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