The Difference Between the Primary and Secondary Market
There are different channels governing securities exchange. When it comes to capital markets, the biggest distinction comes at the highest level: between the primary and secondary market. The two work in tandem to create capital markets as we know them. One is a direct channel for raising capital; the other is a medium of exchange for debt and equity securities.
The differences between primary and secondary markets lie primarily in their functions and in who has access to them. Both are of equal importance. Here’s a look at how they work, what makes them different and what their purposes are.
What Is the Primary Market?
The primary market is where securities are created. In general, this is where companies and governments seeking capital go to issue debt or equity securities to willing investors. It’s sometimes called the “new issue market” or the “IPO market,” since every new transaction is through an initial public offering. Here’s an example:
XYZ Company wants to go public to raise capital. It participates in an IPO, offering 20 million shares at $22 per share. During the IPO book-building process, institutional investors have a chance to place orders for shares, to be distributed to them at the time of the IPO. This all happens before the stock becomes publicly traded on an exchange.
The primary market represents a direct exchange of capital for assets. Institutional investors promise to purchase certain quantities of a security at a fixed price. Once the price of a security is set, its shares get distributed to the primary market. Therefore, it’s an opportunity for early investors to take a strong position before the security goes to the secondary market and its price fluctuates.
Usually (though not always), investors pay less for primary market investments than they would on the secondary market. This depends on the underwriting price for the security.
The purpose of the primary market is to raise funds. The money a company gets from primary market investors is the first infusion of capital for the venture. It’s no small undertaking, either! Companies need to meet with investment banks and regulatory agencies to ensure compliance. Moreover, there are disclosures and financial filings that make this process arduous.
Once approved by the Securities and Exchange Commission (SEC) and other regulatory bodies, companies can begin to issue debt and equity securities (bonds and stocks) to initial investors. In fact, this is the path to the secondary market.
What Is the Secondary Market?
Securities trade in the secondary market. Moreover, prices rise and fall due to supply and demand. This is where everyday investors can buy or sell debt or equity to capitalize on its value. Buying and selling happens through exchanges in the secondary market. And this comes with a commission. Here’s an example:
XYZ Company’s shares list on the NYSE for $22 after its IPO. Maurice, a retail investor, likes the company and decides to buy 100 shares, amounting to a $2,200 investment. After a year, those shares are worth $44. Maurice decides to sell, cashing out his position for $4,400. Maurice is able to cash out because someone else is willing to buy his shares.
The stock market is what most people think of when they picture the secondary market. However, this also includes the bond market and other spot markets. What makes secondary markets distinct is that they’re governed by exchanges. They help to maintain liquidity by facilitating buying and selling. Without exchanges, investors would need to find buyers and sellers on their own. The premium paid in exchange fees is often reflected in the share price and justified by the liquidity that exchanges provide.
The secondary market is also more accessible. Institutional investors in the primary market can buy large blocks of shares – thousands, tens of thousands or even millions. In the secondary market, there’s no minimum. Investors can buy one share if they want. Many brokerages even offer stock slices, which are fractional shares.
There’s another type of market that exists between primary and secondary markets. Sometimes called “other secondary markets,” these markets facilitate the sale of financial assets that aren’t listed on an exchange. Not quite over-the-counter markets, these markets deal with products like mortgages. Banks may issue mortgages, then package them together and sell them through an intermediary market to investors in the form of Ginnie Mae (GNMA) funds, for example.
Intermediary markets open the door to more exotic types of investment vehicles. Some of these investments are available through exchanges. However, they don’t necessarily represent debt or equity belonging to a single entity.
There are different ways to participate in these markets – namely through direct searches for security types, through brokers, through dealers or at auction. Different types of securities crop up in different types of secondary markets.
Capital Markets Work Together
Though different, primary and secondary markets work together. In fact, it’s the primary market that makes the secondary market possible. Likewise, the prices in the secondary market inform the offerings that occur on the primary market.
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Each financial market caters to different investors looking for the same thing: investment opportunities. Moreover, they serve the same purpose: to provide access to capital for those seeking it. Together, they create the basis for our major cash markets.