What is the Secondary Market?
A secondary market is a platform wherein the shares of companies are traded among investors. It means that investors can freely buy and sell shares without the intervention of the issuing company. In these transactions among investors, the issuing company does not participate in income generation, and share valuation is rather based on its performance in the market. Income in this market is thus generated via the sale of the shares from one investor to another.
Some of the entities that are functional in a secondary market include –
- Retail investors.
- Advisory service providers and brokers comprising commission brokers and security dealers, among others.
- Financial intermediaries including non-banking financial companies, insurance companies, banks and mutual funds.
Different Instruments in the Secondary Market
The instruments traded in a secondary market consist of fixed income instruments, variable income instruments, and hybrid instruments.
- Fixed income instruments
Fixed income instruments are primarily debt instruments ensuring a regular form of payment such as interests, and the principal is repaid on maturity. Examples of fixed income securities are – debentures, bonds, and preference shares.
Debentures are unsecured debt instruments, i.e., not secured by collateral. Returns generated from debentures are thus dependent on the issuer’s credibility.
As for bonds, they are essentially a contract between two parties, whereby a government or company issues these financial instruments. As investors buy these bonds, it allows the issuing entity to secure a large amount of funds this way. Investors are paid interests at fixed intervals, and the principal is repaid on maturity.
Individuals owning preference shares in a company receive dividends before payment to equity shareholders. If a company faces bankruptcy, preference shareholders have the right to be paid before other shareholders.
- Variable income instruments
Investment in variable income instruments generates an effective rate of return to the investor, and various market factors determine the quantum of such return. These securities expose investors to higher risks as well as higher rewards. Examples of variable income instruments are – equity and derivatives.
Equity shares are instruments that allow a company to raise finance. Also, investors holding equity shares have a claim over net profits of a company along with its assets if it goes into liquidation.
As for derivatives, they are a contractual obligation between two different parties involving pay-off for stipulated performance.
- Hybrid instruments
Two or more different financial instruments are combined to form hybrid instruments. Convertible debentures serve as an example of hybrid instruments.
Convertible debentures are available as a loan or debt securities which may be converted into equity shares after a predetermined period.
Functions of Secondary Market
- A stock exchange provides a platform to investors to enter into a trading transaction of bonds, shares, debentures and such other financial instruments.
- Transactions can be entered into at any time, and the market allows for active trading so that there can be immediate purchase or selling with little variation in price among different transactions. Also, there is continuity in trading, which increases the liquidity of assets that are traded in this market.
- Investors find a proper platform, such as an organised exchange to liquidate the holdings. The securities that they hold can be sold in various stock exchanges.
- A secondary market acts as a medium of determining the pricing of assets in a transaction consistent with the demand and supply. The information about transactions price is within the public domain that enables investors to decide accordingly.
- It is indicative of a nation’s economy as well, and also serves as a link between savings and investment. As in, savings are mobilised via investments by way of securities.
Types of Secondary Market
Secondary markets are primarily of two types – Stock exchanges and over-the-counter markets.
- Stock exchange
Stock exchanges are centralised platforms where securities trading take place, sans any contact between the buyer and the seller. National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) are examples of such platforms.
Transactions in stock exchanges are subjected to stringent regulations in securities trading. A stock exchange itself acts as a guarantor, and the counterparty risk is almost non-existent. Such a safety net is obtained via a higher transaction cost being levied on investments in the form of commission and exchange fees.
- Over-the-counter (OTC) market
Over-the-counter markets are decentralised, comprising participants engaging in trading among themselves. OTC markets retain higher counterparty risks in the absence of regulatory oversight, with the parties directly dealing with each other. Foreign exchange market (FOREX) is an example of an over-the-counter market.
In an OTC market, there exists tremendous competition in acquiring higher volume. Due to this factor, the securities’ price differs from one seller to another.
Apart from the stock exchange and OTC market, other types of secondary market include auction market and dealer market.
The former is essentially a platform for buyers and sellers to arrive at an understanding of the rate at which the securities are to be traded. The information related to pricing is put out in the public domain, including the bidding price of the offer.
Dealer market is another type of secondary market in which various dealers indicate prices of specific securities for a transaction. Foreign exchange trade and bonds are traded primarily in a dealer market.
Examples of Secondary Market Transactions
Secondary market transactions provide liquidity to all kinds of investors. Due to high volume transactions, their costs are substantially reduced. Few secondary market examples related to transactions of securities are as follows.
In a secondary market, investors enter into a transaction of securities with other investors, and not the issuer. If an investor wants to buy Larsen & Toubro stocks, it will have to be purchased from another investor who owns such shares and not from L&T directly. The company will thus not be involved in the transaction.
Individual and corporate investors, along with investment banks, engage in the buying and selling of bonds and mutual funds in a secondary market.
Advantages of Secondary Market
- Investors can ease their liquidity problems in a secondary market conveniently. Like, an investor in need of liquid cash can sell the shares held quite easily as a large number of buyers are present in the secondary market.
- The secondary market indicates a benchmark for fair valuation of a particular company.
- Price adjustments of securities in a secondary market takes place within a short span in tune with the availability of new information about the company.
- Investor’s funds remain relatively safe due to heavy regulations governing a secondary stock market. The regulations are stringent as the market is a source of liquidity and capital formation for both investors and companies.
- Mobilisation of savings becomes easier as investors’ money is held in the form of securities.
Disadvantages of Secondary Market
- Prices of securities in a secondary market are subject to high volatility, and such price fluctuation may lead to sudden and unpredictable loss to investors.
- Before buying or selling in a secondary market, investors have to duly complete the procedures involved, which are usually a time-consuming process.
- Investors’ profit margin may experience a dent due to brokerage commissions levied on each transaction of buying or selling of securities.
- Investments in a secondary capital market are subject to high risk due to the influence of multiple external factors, and the existing valuation may alter within a span of a few minutes.
Difference between Primary and Secondary Market
|Primary Market||Secondary Market|
|Securities are initially issued in a primary market. After issuance, such securities are listed in stock exchanges for subsequent trading.||Trading of already issued securities takes place in a secondary market.|
|Investors purchase shares directly from the issuer in the primary market.||Investors enter into transactions among themselves to purchase or sell securities. Issuers are thus not involved in such trading.|
|The stock issue price in a primary market remains fixed.||Prices of the traded securities in a secondary market vary according to the demand and supply of the same.|
|Sale of securities in a primary market generates fund for the issuer.||Transactions made in this market generate income for the investors.|
|Issue of security occurs only once and for the first time only.||Here, securities are traded multiple times.|
|Primary markets lack geographical presence; it cannot be attributed to any organisational set-up as such.||A secondary market, on the contrary, has an organisational presence in the form of stock exchanges.|
As for the platform provided by a secondary market, it facilitates stock trading and also enables converting securities into cash. Continuous trading in a secondary market also increases the liquidity of traded assets. Investors are thus encouraged to undertake investments in financial instruments available in secondary markets for substantial corpus creation. It is ideal to take the assistance of fund managers to make the most of investment in a volatile market scenario.