Primary Market & Secondary Market Explained

Fact checked by Katrina MunichielloReviewed by Marguerita ChengFact checked by Katrina MunichielloReviewed by Marguerita Cheng

The primary market refers to the market where securities are created, while the secondary market is one in which they are traded among investors. The premise of how companies issue securities and how investors trade them resides within the primary and secondary markets.

Key Takeaways

• The primary market is where securities are created, while the secondary market is where those securities are traded by investors.
• In the primary market, companies sell new stocks and bonds to the public for the first time, such as with an initial public offering (IPO).
• The secondary market is basically the stock market and refers to the New York Stock Exchange, the Nasdaq, and other exchanges worldwide.

The Primary Market

The primary market is where securities are created. It’s in this market that firms sell (float) new stocks and bonds to the public for the first time. An initial public offering, or IPO, is an example of a primary market. These trades provide an opportunity for investors to buy securities from the bank that did the initial underwriting for a particular stock. An IPO occurs when a private company issues stock to the public for the first time.

For example, company ABCWXYZ Inc. hires five underwriting firms to determine the financial details of its IPO. The underwriters detail that the issue price of the stock will be $15. Investors can then buy the IPO at this price directly from the issuing company. 

This is the first opportunity that investors have to contribute capital to a company through the purchase of its stock. A company’s equity capital is comprised of the funds generated by the sale of stock on the primary market.

Note

Participants in the primary market usually include issuers (such as companies, governments, and other entities seeking to raise capital), underwriters (usually investment banks that help to price and sell the new securities), and investors (institutional and individual) who purchase the newly issued securities. Retail investors are a bit less common in primary markets.

Types of Primary Offering

A rights offering (issue) permits companies to raise additional equity through the primary market after already having securities enter the secondary market. Current investors are offered prorated rights based on the shares they currently own, and others can invest anew in newly minted shares.

Other types of primary market offerings for stocks include private placement and preferential allotment. Private placement allows companies to sell directly to more significant investors such as hedge funds and banks without making shares publicly available. While preferential allotment offers shares to select investors (usually hedge funds, banks, and mutual funds) at a special price not available to the general public.

Similarly, businesses and governments that want to generate debt capital can choose to issue new short- and long-term bonds on the primary market. New bonds are issued with coupon rates that correspond to the current interest rates at the time of issuance, which may be higher or lower than pre-existing bonds.

The important thing to understand about the primary market is that securities are purchased directly from an issuer.

The Secondary Market

For buying equities, the secondary market is commonly referred to as the “stock market.” This includes the New York Stock Exchange (NYSE), Nasdaq, and all major exchanges around the world. The defining characteristic of the secondary market is that investors trade among themselves.

That is, in the secondary market, investors trade previously issued securities without the issuing companies’ involvement. For example, if you go to buy Amazon (AMZN) stock, you are dealing only with another investor who owns shares in Amazon. Amazon is not directly involved with the transaction.

In the debt markets, while a bond is guaranteed to pay its owner the full par value at maturity, this date is often many years down the road. Instead, bondholders can sell bonds on the secondary market for a tidy profit if interest rates have decreased since the issuance of their bond, making it more valuable to other investors due to its relatively higher coupon rate.

The secondary market can be further broken down into two specialized categories:

Auction Markets

In the auction market, all individuals and institutions that want to trade securities congregate in one area and announce the prices at which they are willing to buy and sell. These are referred to as bid and ask prices. The idea is that an efficient market should prevail by bringing together all parties and having them publicly declare their prices.

Thus, theoretically, the best price of a good need not be sought out because the convergence of buyers and sellers will cause mutually agreeable prices to emerge. The best example of an auction market is the New York Stock Exchange (NYSE).

Dealer Markets

In contrast, a dealer market does not require parties to converge in a central location. Rather, participants in the market are joined through electronic networks. The dealers hold an inventory of security, then stand ready to buy or sell with market participants. These dealers earn profits through the spread between the prices at which they buy and sell securities.

An example of a dealer market is the Nasdaq, in which the dealers, who are known as market makers, provide firm bid and ask prices at which they are willing to buy and sell a security. The theory is that competition between dealers will provide the best possible price for investors.

Note

The so-called “third” and “fourth” markets relate to deals between broker-dealers and institutions through over-the-counter electronic networks and are therefore not as relevant to individual investors.

Key Differences Between Primary Market and Secondary Market

The primary market serves as the initial platform for companies and governments to raise capital by issuing new securities to investors. Alternatively, the secondary market facilitates the trading of already issued securities among investors. It provides liquidity to investors who wish to buy or sell stocks, bonds, or other financial instruments previously acquired through the primary market or subsequent secondary market transactions.

In the primary market, transaction participants include the issuing entity seeking to raise funds, underwriters who assist in structuring and selling the securities, and investors who purchase the newly issued securities. On the other hand, the secondary market involves transactions among investors themselves including individual investors, institutional investors, traders, and market makers. The issuer of the securities is generally not directly involved in secondary market transactions once the initial issuance is completed.

Primary markets primarily trade newly issued securities ranging from stocks, bonds, and other financial instruments. The secondary market trades these securities as well. However, the secondary market also includes complex financial instruments like derivatives, providing a broader range of investment opportunities beyond initial offerings.

The primary market provides entities with access to funding necessary for growth and development. It facilitates economic expansion by letting companies raise capital through equity or debt offerings. The secondary market enhances market efficiency by providing liquidity and price discovery. It allows investors to trade securities more freely without regard to economic development.

The OTC Market

Sometimes you’ll hear a dealer market referred to as an over-the-counter (OTC) market. The term originally meant a relatively unorganized system where trading did not occur at a physical place, as we described above, but rather through dealer networks. The term was most likely derived from the off-Wall Street trading that boomed during the great bull market of the 1920s, in which shares were sold “over-the-counter” in stock shops. In other words, the stocks were not listed on a stock exchange, they were “unlisted.”

Over time, however, the meaning of OTC began to change. The Nasdaq was created in 1971 by the National Association of Securities Dealers (NASD) to bring liquidity to the companies that were trading through dealer networks. At the time, few regulations were placed on shares trading over-the-counter, something the NASD sought to improve. As the Nasdaq has evolved over time to become a major exchange, the meaning of over-the-counter has become fuzzier.

Nowadays, the term “over-the-counter” generally refers to stocks that are not trading on a stock exchange such as the Nasdaq, NYSE, or American Stock Exchange (AMEX). This means that the stock trades either on the over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these networks is an exchange; in fact, they describe themselves as providers of pricing information for securities. OTCBB and pink sheet companies have far fewer regulations to comply with than those that trade shares on a stock exchange. Most securities that trade this way are penny stocks or are from very small companies.

For these reasons, while the Nasdaq is still considered a dealer market and, technically, an OTC, today’s Nasdaq is also a stock exchange and, therefore, it is inaccurate to say that it trades in unlisted securities.

Third and Fourth Markets

You might also hear the terms “third” and “fourth” markets. These don’t concern individual investors because they involve significant volumes of shares to be transacted per trade. These markets deal with transactions between broker-dealers and large institutions through over-the-counter electronic networks.

The third market comprises OTC transactions between broker-dealers and large institutions. The fourth market is made up of transactions that take place between large institutions.

The main reason these third- and fourth-market transactions occur is to avoid placing these orders through the main exchange, which could greatly affect the price of the security. Because access to the third and fourth markets is limited, their activities have little effect on the average investor.

How Do Primary Markets Function?

Primary markets function through the issuance of new securities. Companies work with underwriters, typically investment banks, to determine the initial offering price, buy the securities from the issuer, and sell them to investors. The process involves regulatory approval, creating prospectuses, and marketing the securities to potential investors. Once the securities are sold, the issuing entity receives the capital raised, which is used for business purposes.

How Do Secondary Markets Function?

Secondary markets function as platforms for trading existing securities. These markets include stock exchanges like the NYSE and NASDAQ, as well as OTC markets. Investors buy and sell shares through brokers, and the prices of securities are determined by supply and demand dynamics.

What Are the Key Differences Between Primary and Secondary Markets?

The primary market involves the issuance of new securities directly from issuers to investors, raising new capital for the issuer. In contrast, the secondary market involves the trading of existing securities between investors, providing liquidity and the ability to trade. 

What Is an IPO?

An initial public offering is the process through which a private company becomes a publicly traded company by issuing shares to the public for the first time. This process involves several steps, including filing with regulatory authorities, setting an initial price, and selling shares to institutional and individual investors. All of this happens within the primary market.

The Bottom Line

The primary market is where securities are initially issued and sold by issuers to raise capital, while the secondary market is where these already issued securities are traded among investors. Knowledge of these markets helps know how stocks, bonds, and other securities are traded as the primary market is where companies can raise funds for growth while secondary markets are where investors can speculate on the prospects of those companies.

Read the original article on Investopedia.