The Secondary Market
Once a security has been issued in the primary market, all subsequent trading between investors happens in the secondary market. This is where the vast majority of securities trading takes place.
What Is the Secondary Market?
- The secondary market is where existing securities are bought and sold after the initial offering
- The issuer does not receive proceeds from secondary market transactions. The selling investor receives the money.
- The secondary market is far larger in trading volume than the primary market
Think of it this way: The primary market is like buying a new car from the manufacturer. The secondary market is like buying a used car from another owner. The manufacturer (issuer) does not get paid when a used car changes hands.
Exam Tip: Gotchas
- The issuer gets nothing from secondary market trades. Only the selling investor receives proceeds.
Why the Secondary Market Matters
The secondary market serves two important functions:
- Liquidity - The ability for investors to quickly convert securities to cash. Without a secondary market, investors would be stuck holding securities until maturity or until the issuer bought them back.
- Price discovery - Ongoing trading establishes the current market value of a security. The constant flow of buy and sell orders reveals what investors collectively believe a security is worth at any given moment.
Secondary Market Venues
| Venue | Description | Examples |
|---|---|---|
| Physical exchanges | Centralized locations where securities are traded via an auction process | NYSE trading floor (though now mostly electronic) |
| Electronic exchanges | Fully automated matching of buy and sell orders | Nasdaq, NYSE Arca |
| Over-the-counter (OTC) | Decentralized network of dealers trading via negotiation | OTC Bulletin Board, OTC Markets (Pink Sheets) |
Memory Aid: Exchange = Listed = Auction; OTC = Unlisted = Negotiated
Auction Market vs. Dealer Market
- Auction market - Buyers and sellers submit competing bids and offers. Trades execute when a bid price matches an ask price. The NYSE is the best-known auction market.
- Dealer market - Dealers (market makers) buy and sell securities from their own inventory. They quote both a bid price (what they will pay) and an ask price (what they will sell for). The difference is the bid-ask spread, which is how dealers earn a profit.
Think of it this way: An auction market is like eBay, where buyers bid against each other. A dealer market is like a used car lot, where the dealer buys cars at one price and sells them at a higher price. The markup is the dealer's profit (the spread).
Exam Tip: Gotchas
- Nasdaq started as an over-the-counter (OTC) dealer market but is now a registered national securities exchange. For exam purposes, know its dealer-market roots.
- The bid-ask spread is how dealers (market makers) are compensated. Wider spreads mean higher trading costs for investors.
Exchange-Listed vs. OTC Securities
| Feature | Exchange-Listed | OTC |
|---|---|---|
| Listing standards | Must meet financial, size, share price, and governance requirements | Fewer listing requirements |
| Regulatory oversight | Higher; exchanges are registered with the SEC | Lower; less regulatory scrutiny |
| Transparency | All orders and prices visible | Prices determined through dealer negotiation |
| Liquidity | Generally higher (more buyers and sellers) | Generally lower (wider bid-ask spreads) |
Exam Tip: Gotchas
- Exchange-listed securities must meet strict listing standards, including minimum financial thresholds (revenue, market cap, share price) and corporate governance requirements. If a listed company falls below these standards, the exchange may delist the security, forcing it to trade OTC.
- OTC securities are NOT "unregulated." They have less regulatory oversight than exchange-listed securities, but they are still subject to securities laws.
Third and Fourth Markets
- Third market - Exchange-listed securities traded in the OTC market (off the exchange). This allows institutional investors to execute large trades without affecting the exchange price.
- Fourth market - Direct institution-to-institution trading with no broker-dealer involved. Electronic Communication Networks (ECNs) facilitate these trades.
Exam Tip: Gotchas
- Third market = listed securities traded OTC. Fourth market = institutions trading directly with each other.
- The fourth market bypasses broker-dealers entirely. ECNs match buy and sell orders electronically without a middleman.