Guide to Primary and Secondary Markets
The world of finance is filled with complicated concepts and terms that may refer to something specific or general. The word “market,” for instance, is often used as an overarching phrase by finance insiders and laymen alike, which encompasses both the primary market and the secondary market.
Although both the primary market and secondary market are related to securities, they are distinctly different concepts that work in conjunction to facilitate trade and investment. Comprehending their nuances, similarities, and differences is a fundamental step towards grasping the intricacies of stocks, bonds, and other types of securities.
Looking for more information on the difference between primary and secondary markets? Learn all the details here.
Guide to Primary and Secondary Markets
As mentioned, the word market can become a catch-all term that is used to refer to several things, including primary and secondary markets. Usually, though—as Business Insider notes— it’s meant to refer to the secondary market:
Think of investing in the market as purchasing a whole basket of stocks all mixed together. For simplicity, “the market” usually means the S&P 500 (the 500 largest company stocks you can buy). There are other definitions, but this is the simplest. Buying “the market” means you own the whole basket of stocks, and buying this basket has given a return of 9.55% per year on average.
Despite that, as the name suggests, it’s impossible to have the secondary market without the primary market. So, in order to understand both, we need to go to the beginning.
What is the Primary Market?
The primary market, also known as the new issues market, is the place where securities are first created so that they can undergo their first investor sale. So, when a company wishes to publicly sell a portion of the business, this transaction occurs on the primary capital market, and the securities are purchased directly from the issuer. Securities offered by the primary markets can refer to:
- Corporate bonds
- Government bonds
Any such primary market issuance is subject to strict federal regulations and necessitates the filing of statements and documentation with the Securities and Exchange Commission (SEC). These and other security agencies must give it the greenlight of approval before a business can go public.
With your average primary market transaction, there tends to be three key entities involved. Yahoo Finance writes:
First, there’s the company issuing the new securities. Secondly, there are investors who purchase them. Finally, there’s a bank or underwriting firm that oversees and facilitates the offering. The bank or underwriting firm determines the accurate value and sale price of the new security.
Such trades provide investors with an opportunity to purchase marketable securities from the investment banks that originally underwrote the particular company or entity. That said, it’s important to note that the sale is typically limited to large institutional investors that have been enlisted by an investment banker and have agreed to purchase large volumes. In addition, prices can be volatile due to the difficulty of forecasting market demand. Smaller investors are typically shut out from these first offerings since both the company and its investment bank are in a rush to meet the required trade volume.
But why would a company want to issue securities? Typically, it grants them the freedom and opportunity to:
- Reduce debt on the balance sheet
- Develop new products
- Fund other investment avenues
- Expand the company’s global reach
How Primary Market Securities are Sold
These days, there are four primary ways that investors are able to purchase securities on the primary market. These include:
- Initial Public Offering (IPO) – The IPO is the most common method a company sells securities on the primary market. When this occurs, the company provides a certain percentage of shares to the public in order to quickly raise capital, especially if the private investor market has dried up.
It’s worth noting that an IPO can be risky for both the company and its initial investors:
- Company – Now that it’s publicly traded, the company is subject to the rules and regulations of the SEC.
- Investors – Early investors get an opportunity to buy company shares at a theoretically low price, however, not every once-private company that hits the open market is able to keep up enthusiasm. If a company flags, demand for shares drops, which in turn reduces prices.
- Rights Offering – Sometimes referred to as a “rights issue,” this produces new shares for purchase while imposing a strict limit on which investors have access to the sale. Typically, the company will set a specific share price and then offer it to designated investors. Once purchased, the investor can then sell their rights to someone else, and so forth. According to Investopedia:
A company can raise more equity in the primary market after entering the secondary market through a rights offering. The company will offer prorated rights based on share investors already own. Another option is a private placement, where a company may sell directly to a large investor, such as a hedge fund or a bank. In this case, the shares are not made public.
- Private Placement – Companies also have the ability to offer securities to a small group of investors, whether commercial or individual. So, this might involve an investment bank, hedge fund, or a billionaire. Since these are private offerings, they are subject to fewer regulatory issues, which make them ideal for startups and companies that are in their early growth stages, require capital, but don’t wish to go public yet.
- Preferential Allotment – Quite similar to private placement, it offers a hand picked group of investors a share of securities at a price that may or may not be set by the market price. Owners of shares don’t receive voting rights but receive the first payments on dividends.
What is the Secondary Market?
This is what most people think of when they hear the word market since it primarily refers to auction markets via stock exchanges. Per Statista, the top ten secondary market exchanges according to market capitalization are:
- New York Stock Exchange (NYSE) – $23.21 Trn market Cap
- Nasdaq – $11.22 Trn market cap
- Japan Exchange Group – $5.61 Trn market cap
- Shanghai Stock Exchange – $5.01 Trn market cap
- Hong Kong Exchange – $4.31 Trn market cap
- Euronext Europe – $4.27 Trn market cap
- London Stock Exchange Group – $3.97 Trn market cap
- Shenzhen Stock Exchange – $3.36 Trn
- TMX Group (Canada) – $2.22 Trn market cap
- Bombay Stock Exchange (India) – $2.18 market cap
Secondary financial markets are where securities can be traded after the initial sale on the primary market. This opens up investment opportunities to smaller investors who missed out on the chance to purchase securities via the IPO. Such investments are open to all so long as they are willing and able to pay the asked share price.
From there, the issuing companies are removed from the exchange since they’re not being directly purchased from the issuer anymore. Instead, they’re being bought and sold from one investor to another. This tends to create an open market on stock prices, which rapidly fluctuate according to supply and demand.
It’s worth noting that exchanges aren’t the only secondary market where securities can be bought and sold. There are also over-the-counter OTC markets. Corporate Finance Institute writes:
In the over-the-counter market, securities are traded by market participants in a decentralized place (e.g., the foreign exchange market). The market is made up of all participants in the market trading among themselves. Since the over-the-counter market is not centralized, there is competition between providers to gain a higher trading volume for their company. The prices for the securities vary from company to company. Therefore, the best price may not be offered by every seller in OTC markets.
These days, OTC is often referred to as stocks that aren’t traded on a primary stock exchange and instead are listed on pink sheets.
Benefits of Secondary Financial Markets
So, why does the secondary market matter? First and foremost, it’s where much of a company’s value is derived from, thanks to the way that prices are driven towards their fair market value via supply and demand. That said, there are several additional reasons why it’s critically important, such as:
- It helps to gauge the economic conditions within the country or on a global scale. The rises and falls of the stock market share prices can help indicate booming growth or recessionary decline.
- Increases liquidity since stocks can be easily purchased or sold for cash value.
- It sets the price and watermark for a company’s share value and total value.
- It creates an open market of exchange based on the concept of fair value and market efficiency. Intuitively, it demonstrates that those selling the share value it less than its current price (whereas those buying value it more than its current price).
The primary and secondary markets work together in order to create an exchange of marketable securities that benefit all interested parties. It’s worth noting, however, that there is always a great deal of risk involved whichever market the securities purchase takes place in. As such, it’s important to understand that risk so you can carefully weigh and measure each and every new deal opportunity.
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- Business Insider. The Only 3 Things Beginning Investors Need To Know About The Stock Market. https://www.businessinsider.com/basics-explanation-stock-market-2014-10
- Investopedia. Understanding Primary vs. Secondary Markets. https://www.investopedia.com/ask/answers/012615/whats-difference-between-primary-and-secondary-capital-markets.asp
- Statista. Largest stock exchange operators worldwide as of May 2019. https://www.statista.com/statistics/270126/largest-stock-exchange-operators-by-market-capitalization-of-listed-companies/
- Corporate Financial Institute. What is a Secondary Market? https://corporatefinanceinstitute.com/resources/knowledge/finance/secondary-market/