What is secondary market? How does it work?

The financial system consists of two different markets, the primary market and the secondary market. Both of these provide different services to investors. While in the primary market, financial securities such as shares and bonds are issued for the first time, the secondary market is a place to trade and resell these securities.

A secondary market is a platform where investors buy and sell securities that are already owned. Typically, the security issuing company does not participate in secondary market transactions. It is simply a transaction between the buyer and the seller of the security. This indicates the income generated in the market is solely through the transaction of securities between one investor to another.

Any size of investor can participate in the secondary market. Furthermore, in the secondary market, the value or price of a security is determined by its demand and supply metrics. A higher demand for a security, translates to higher value and vice-versa.

How is secondary market different from the primary market?

The primary market and secondary are different from each other on the basis of their functions and the services they provide.

Primary market is a platform where the initial offering of the security takes place. This means the securities are offered to the public for the first time. Generally, large institutional buyers participate in the primary market. These institutional buyers purchase securities in large quantities in the primary market.

Let’s refer to an example to understand the difference between the primary and secondary markets. Companies looking to raise capital from the general public launch their Initial Public Offering (IPO). This is the first time the companies offer the general public to invest in their stocks and become shareholders.

A company’s IPO is introduced in the primary market. Once the IPO is closed, the allotment of stocks will take place. If you are allotted stocks in the IPO and wish to sell them, you can do so in the secondary market. Once the stock enters the secondary market, it can be freely traded, or bought and sold, on stock exchanges.

What are the types of secondary market?

There are mainly two types of secondary market – Stock exchange and Over the Counter (OTC) market. Following is a detailed description of both market types:

• Stock exchange

Stock exchange is an important part of the stock market. It is a platform where you can trade various securities like stocks, bonds, commodities, and foreign currency. In India, there are two popular stock exchanges to trade in – National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).

• Over the Counter market

Over the Counter (OTC) market is a decentralised market. Here a trade directly takes place between two parties. There is absolutely no involvement of a central exchange or broker. Given this, the participants themselves quote the price at which they would like to buy or sell a security. A trade can be made without both the buyer and seller being aware of the security price as well. This indicates a lack of transparency in transactions.

Also, since the OTC market is not regulated by a proper central authority, the cases of fraud tend to be very high.

Functions & benefits of secondary market

Secondary markets provide a place for investors to easily trade their securities. Investors can sell their holdings anytime in the secondary market to a huge number of buyers available. Investors in need of cash can simply liquidate their positions and holdings and raise cash.

Investors can make money by efficiently trading securities in the secondary market. This market helps in enhancing liquidity in the financial system and capital formation for companies and investors.

The secondary market is highly regulated. The stock exchanges have several regulations and measures to protect and assure the maximum security of investors’ funds. It also provides all the necessary information about every security issuing company, helping investors make informed decisions.

The secondary market also acts as a mechanism for fair price discovery of the shares and securities traded on it. The prices of securities also react and adjust to any new development or information that is made public.

Limitations of secondary market

There are certain limitations or drawbacks of investing in the secondary market, that are unavoidable.

Secondary markets are unpredictable. Stock prices fall and rise in a fraction of a second. Hence, it involves a high degree of risk. Investors are advised to act in accordance with their risk appetite and avoid putting more money in the market than they can afford to lose.

Investors have to pay certain fees, commissions and brokerage to invest in the secondary market. A high amount of these charges can negatively impact the profit margins.

Bottom line

The primary market and secondary market play an essential role in the economic growth of a company. While both of these markets have their own benefits and limitations, they are equally important components of the financial system and essential for the efficient functioning of the economy.