Primary Market vs. Secondary Market: What’s the Difference?

Primary Market vs. Secondary Market: An Overview

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

The Primary Market

The primary market is where securities are created. Firms sell or 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.

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 consists of the funds generated by the sale of stock on the primary market.

Types of Primary Offerings

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. Preferential allotment offers shares to select investors, usually hedge funds, banks, and mutual funds, at a special price that’s not available to the general public.

Businesses and governments that want to generate debt capital can also 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. This may be higher or lower than those of pre-existing bonds.

Securities on the primary market are purchased directly from an issuer.

The Secondary Market

The secondary market for buying equities 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.

Investors in the secondary market trade previously issued securities without the issuing companies’ involvement. You’re dealing only with another investor who owns shares in Amazon if you go to buy Amazon (AMZN) stock. Amazon isn’t directly involved with the transaction.

A bond is guaranteed to pay its owner the full par value at maturity in the debt markets but this date is often many years down the road. Bondholders can instead sell bonds on the secondary market for a tidy profit if interest rates have decreased since the issuance of their bond. This makes 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

All individuals and institutions that want to trade securities congregate in one area in the auction market. They announce the prices at which they’re 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.

The best price of a good therefore doesn’t have to be sought because the convergence of buyers and sellers will cause mutually agreeable prices to emerge, at least in theory. The best example of an auction market is the New York Stock Exchange (NYSE).

Dealer markets

A dealer market doesn’t require parties to converge in a central location. Participants in the market are instead joined through electronic networks. The dealers hold an inventory of security and 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.

The Nasdaq is an example of a dealer market. The dealers are known as market makers. They provide firm bid and ask prices at which they’re willing to buy and sell a security. The theory is that competition between dealers will provide the best possible price for 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. The secondary market facilitates the trading of already issued securities among investors. It provides liquidity to investors who want to buy or sell stocks, bonds, or other financial instruments that were previously acquired through the primary market or subsequent secondary market transactions.

Transaction participants in the primary market 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. The secondary market involves transactions among investors themselves including individual investors, institutional investors, traders, and market makers. The issuer of the securities generally isn’t directly involved after 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 but the secondary market also includes complex financial instruments like derivatives. This provides 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

You’ll sometimes hear a dealer market referred to as an over-the-counter (OTC) market. The term originally meant a relatively unorganized system where trading didn’t occur at a physical place but rather through dealer networks. It was most likely derived from the off-Wall Street trading that boomed during the great bull market of the 1920s. Shares were sold “over-the-counter” in stock shops. The stocks weren’t listed on a stock exchange. They were “unlisted.”

The meaning of OTC began to change over time, however. 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. Few regulations were placed on shares trading over the counter at that time. NASD sought to improve this. The meaning of over-the-counter has become fuzzier as the Nasdaq has evolved to become a major exchange.

The term “over-the-counter” now generally refers to stocks that aren’t trading on a stock exchange. The stocks trade either on the over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these networks is an exchange. They describe themselves as providers of pricing information for securities.

The Nasdaq is still considered a dealer market and, technically, an OTC but it’s also a stock exchange and it’s inaccurate to say that it trades in unlisted securities.

Third and Fourth Markets

The terms “third” and “fourth” markets 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 deals with OTC transactions between broker-dealers and large institutions. The fourth market is made up of transactions that take place between large institutions.

These third- and fourth-market transactions occur by placing these orders through the main exchange which could greatly affect the price of the security. Their activities have little effect on the average investor because access to the third and fourth markets is limited.

How Will I Use This in Real Life?

You can purchase securities through either market if you want to invest. The market that best suits you will depend on your goals, needs, and risk tolerance.

Say 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. You can buy the IPO at this price directly from the issuing company. You won’t have any stock history to fall back on and consult when making your decision, however. The “I” in IPO stands for initial. You’re entering new ground here.

You can purchase Company ABCWXYZ securities on the secondary market if you want to wait a while because this market trades previously issued securities. Company ABCWXYZ won’t be involved in the transaction. You’ll buy shares from another investor who already owns existing Company ABCWXYZ stock. The company now has some history on the exchange.

The Bottom Line

The primary market is where securities are initially issued and sold by issuers to raise capital, The secondary market is where these already-issued securities are traded among investors. Knowledge of these markets helps investors understand how stocks, bonds, and other securities are traded.

The primary market is where companies can raise funds for growth. Secondary markets are where investors can speculate on the prospects of these companies.