Secondary Market

What is the Function of Secondary Markets?

Secondary markets serve several important functions within the financial system.

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How Does the Secondary Market Work?

The secondary markets function as a platform where securities issued on a prior date can be bought and sold among investors, including retail investors and institutional investors like hedge funds and mutual funds.

The process of transactions on the secondary markets is as follows.

• Exchange Listing → The securities eligible to be traded in the secondary market are initially publicly listed on an exchange via an initial public offering (IPO) or direct listing.
• Orders and Execution → The buy and sell order requests can be submitted to the secondary markets by investors at any given moment. However, the orders will NOT be filled if the market is not yet open, or it is a non-trading day. One exception is when corporate executives sell pieces of their equity stakes in the aftermarket (post-market close). The most common types of orders placed are market orders in which the sale is executed at the current market price, or limit orders, where the order is executed only if the specified price is met by the bid. Upon receipt of the order confirmation, the orders are routed to the appropriate market (or exchange) for the transaction to occur.
• Matching Buyers and Sellers → The secondary market matches buyers and sellers of securities based on their order details. If a buy order meets the offer price set by the seller, the trade executes. Once complete, the platform confirms and facilitates the ownership transfer of the securities from the seller to the buyer.
• Clearing and Settlement → Once a trade is executed, the clearing and settlement process subsequently occurs, which involves verifying the trade details, updating the ownership records to abide by SEC regulations, and transferring the securities (and funds) between the seller and buyer side. Usually, a clearinghouse possesses the role in ensuring the accuracy of the settlement of trades, as well as a compliance team to manage risk, i.e. to review “red flags” and file a report if deemed necessary.
• Price Determination (“Efficient Market”) → The purchase and sale of securities in the secondary market – where the buyers and sellers determine the purchase price and selling price, respectively, enables the market price to reflect the supply and demand dynamics of a given security in the market. Hence, the secondary market is frequently referred to as the “open market”, as the stated prices reflect the current supply and demand dynamics, investor sentiment (and near-term and long-term outlook), prevailing economic conditions, and recent performance by the issuing entity.

What is the Difference Between Primary vs. Secondary Markets?

The primary market and the secondary market are two distinct parts of the financial market:

• Primary Market → The primary market is where new securities are issued for the first time, most often by a corporation as part of a capital raise. The market participants that purchase the issuance of new securities are predominately institutional investors (e.g. hedge funds), mutual funds, insurance companies, and other entities with a substantial amount of capital on hand. In the primary market, investors purchase the newly issued securities directly from the issuer, and the funds raised as part of the capital raise go into the issuer’s pocket directly, net of fees. The most common transactions that occur on the primary market include initial public offerings (IPOs), corporate bond issuances, and seasoned equity offerings (SEO).
• Secondary Market → The secondary market, on the other hand, is where securities issued on a prior date are traded among a wide range of investors. Therefore, investors actively buy and sell existing securities from each other, without the direct involvement from the original issuer, i.e. the trading activity in the secondary market is independent of the initial capital raise.

What are the Different Types of Secondary Markets?

There are various types of secondary markets, each catering to a specific type of financial securities.

• Stock Market → The stock market, or “public equities market”, is a secondary market where previously issued shares of publicly traded companies can be bought and sold.
• Bond Market → The bond market is a secondary market where previously issued bonds are traded. The bonds that trade in the secondary market are debt instruments issued by governmental entities, municipalities, and corporations – which can be categorized as government bond markets, municipal bonds market and corporate bonds markets, respectively.
• Commodity Market → The commodity market is a secondary market where commodities, such as gold, silver, oil, agricultural products, and raw materials, are traded. The transactions of commodities can occur on exchanges, as well as over-the-counter (OTC).
• Foreign Exchange Market (FX) → The foreign exchange market (FX) – often abbreviated as the forex market – facilitates the trading of currencies. The unique characteristic of the FX market is that a substantial portion of the trading activity pertains to more speculative strategies and hedging portfolio risk.
• Derivatives Market → The derivatives market involves the trading of derivatives, which are financial instruments where the stated values are derived from underlying assets. For instance, common securities are options, futures, swaps, and other complex financial contracts.
• Over-the-Counter (OTC) Market → The over-the-counter (OTC) market is a secondary market that is distinct in that the platform is decentralized and the financial assets are traded directly between buyers and sellers, i.e. there is no physical trading floor or central exchange (“middleman”). The OTC markets are frequently used for transactions involving stocks, bonds, derivatives, and other financial instruments that are not listed on formal exchanges.