What is the Secondary Market for Stocks?
Secondary Market is a market where securities are offered to the general public after being offered in the primary market and such securities are usually listed on the Stock Exchange. The major portion of trading happens in the such a market and can be divided into two types – equities and debt market.
How Does It work?
It is a great place for investors to trade securities. For a company, the secondary market acts as a point from which the company can monitor and control the transactions and which also shape the management decisions.
Look at the picture above to get the idea. First, the companies issue stocks to its investors. In the financial term, it’s called IPO (initial publicInitial PublicAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange. offering). Then once these companies get listed on the stock exchange, these investors go to this market and sell these stocks to other investors. It’s a simple thing to understand. This is a place where investors buy or sell their stocks and make profits or to avoid more losses in the future.
Types of Secondary Market
It can also be divided into four parts – direct search market, broker market, dealer market, and auction market.
We will look at each of them in detail.
- Direct Search Market: This is the least efficient as the buyers and the sellers get involved in search of each other without taking any assistance. Transactions are not as frequent as other markets. No broker gets interested in the market as transactions are infrequent. And there’s very little chance for each party to get the best price.
- Broker Market: This market is more efficient than the direct search market. The brokers are involved in the transactions as they earn a commission for bringing the buyers and the sellers together. In the broker market, the brokers share extensive information about the prices of the stocks.
- Dealer Market: Here, the efficiency is much more than the broker market. The reason behind this is in the dealer marketDealer MarketA dealer market is where dealers engage in buying and selling a specific financial instrument using their account electronically without a third party and make the market by quoting the offer price and bid price., there is constant bidding of the stocks; thus, no time gets wasted in order to search for a partner. Dealers own the inventories of stocks, and these stocks are being sold and bought to earn profits. There are two things that are important here. Firstly, in the dealer market, there is no time wastage. Secondly, the dealers can provide a guarantee for the inventories of stock they hold. NASDAQ is the best dealer market.
- Auction Market: In an auction marketAuction MarketAuction Market is a marketplace where the buyers and sellers trade stock by bidding. The price is calculated based on the highest amount a buyer is ready to pay and the lowest amount a seller is ready to accept. , the buyers and sellers get into a negotiation and bargain for the price. The person who acts as an arbitrator between the buyers and sellers is the specialist and facilitates proper dealing and filling orders by public customers. This person is also a dealer of a certain stock. The New York Stock ExchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ. (NYSE) is the most efficient stock exchange in the USA.
Importance of Secondary Market
Before discussing points of arguments, let’s look at an example to understand its value and why it’s crucial.
In research done in 2011, the researchers gathered data about sales of new homes and old homes from 1960 to 2010. Astonishingly, it was found that the sales of old/existing homes are 6-12 times more than the sales of new homes.
Let’s say that the new homes that are being sold represent the primary marketThe Primary MarketThe primary market is where debt-based, equity-based or any other asset-based securities are created, underwritten and sold off to investors. It is a part of the capital market where new securities are created and directly purchased by the issuer.. Let’s also assume that the promoters of new homes are also builders of new homes and direct seller of these new homes. When a buyer is directly buying a new home, he becomes a primary buyer. And when he sells the home to another buyer, then this home enters the secondary market.
Now let’s say there is no market. What would happen then?
Possibly these things would happen if there is no secondary market of homes –
- No-one will buy new homes from the primary market as there will be no chance of selling it out.
- There will be no flexibility in the prices of homes.
- Even if people buy new homes, these new homes become permanent assets, and there would be no chance to transfer the ownership other than by inheritance.
With this simple example, now, thus, it’s clear the significance of such a market.
Let’s what are the specific reasons for which the significance of such a market will never cease to exist.
- A great exit route for IPO investors: As the liquidity in this market is much more, the risk premium is much less. That means you, as an investor, would be able to sell stocks as fast as possible in the market. That means you will get the current market price, and thus the perceived risk is much lower. Such a market reduces risk premiumRisk PremiumRisk Premium, also known as Default Risk Premium, is the expected rate of return that the investors receive for their high-risk investment. You can calculate it by deducting the Risk-Free Investment Return from the Actual Investment Return. through its liquidity; that means the value of traded financial assets gets increased. Thus the secondary market becomes the best exit strategy for IPO investors as they will get more interest in IPOs.
- Freedom to buy/sell: It provides an organized place where buyers and sellers can come together and buy and sell stocks. They don’t need to worry about any scams or frauds. Such a market offers a safe environment where buyers and sellers feel safe and under protection. The reason for which they feel safe is that this market allows them to be free and buy or sell the stocks they want to hold/hold whenever they want.
- Opportunity to buy or sell further: Go back to the example we gave in the beginning. What will happen if there’s no such market? The people who want to buy a home from the primary market won’t buy any because there would be no opportunity to sell their new homes in the market. This is true in the case of stocks also. As the secondary market for stocks exists, people don’t need to worry about selling the stocks if they don’t want in the future in the secondary market for stocks. Thus they buy stocks from the primary market without any anxiousness. And as there is no need to permanently hold the stocks, they buy as much as they want, and the companies also get benefited from the IPOs. So you can understand that without the existence of this market, the opportunity to buy or sell further is not there.
- Private markets: Not all companies are big and can adhere to the rules and regulations of the primary market. Moreover, there are many requirements to be eligible for IPOs. For start-ups and small companies, it’s not always possible to go to the public to source the funds. The existence of such a market has made things easier for them. They don’t need to worry about sourcing funds as in the market, they can get funds through over-the-counter stock selling via a dealer network, and the whole thing remains completely private. Without the existence of a secondary market, the private market won’t exist.
- Helps in economic growth: In the primary market, freedom is limited. But in the secondary market, you can choose which stock to invest in and which stock is to let go of. As it will create more economic growth for the investor, ultimately, it will help the whole economy to grow. Thus it helps in creating the most productive investment proposal for prosperity and economic growth as a whole.
- A great place for companies to monitor and control: This market doesn’t only allow the unlisted stocks to get traded; instead, the companies which are listed in the stock exchanges get the benefit from this market. These companies issue their stocks directly to the investors in the primary market. But this market acts as a conduit to provide them information about the demand of their stocks in the market and also about any downfall or upward movement in the market. This allows them to take immediate action, and if something goes wrong, they can take measures to improve the situation without getting delayed in collecting the information.
On an end note, we can say that the secondary market for stocks has a massive role in any market. Most people don’t realize this until they become part of it.
- To illustrate another example, simply think about used bookstores. All are not fond of books, and many like to buy used books to reduce costs. So the place that allows these both buyers and sellers to come together is the secondary market of books. People who want to get rid of books sell them to people who want to own them. Thus the sellers get the money, and buyers get the ownership.
- Another example is the market for used cars. People who want to sell their cars sell cars to people who want cars at discounted rates. So both parties fulfill each other’s desires.
This article has been a guide to what is Secondary market? Here we discuss the types of the secondary market of stocks (Direct Search market, Broker Market, Auction Market, Dealers Market) along with its importance. You can also go through our recommended articles on Corporate Finance –