Secondary Market

Secondary Market - Palouse Falls East, WA, USA
Secondary Market

The term “secondary market” is used to include organized exchanges, the over-the-counter market (OTC), the third, and the fourth markets. The existence of the secondary market is explained by the need for providing an efficient mechanism for the resale of securities that were previously purchased in the primary market.

The trading of the securities is between the investors; consequently no funds are transferred to the issuing corporation. Volume of trading in the secondary markets is larger than that in the primary markets.

The organized exchanges are centralized institutions in which buyers and sellers competitively determine prices of the traded securities. They are characterized by the following:
  1. Have known locations
  2. Have permanent staf
  3. Disseminate continuously and instantaneously all the required information on the listed companies, listed securities, and trading
  4. Have regulatory bodies that legally impose several restrictions on all the aspects of trading securities in order to provide a fair trading ground for the participants
  5. Provide a continuous mechanism to bring together traders of securities
  6. Have minimum transactions costs

The OTC market handles all securities transactions that are not conducted in the organized exchanges. In other words, the securities of unlisted corporations are mostly traded in this market. It does not have any central location and consists of a network of dealers linked together by telecommunication devices. Once the security prices are determined by negotiations, the dealers in this market can directly deal with each other and with customers.

The third market serves the needs of large institutions that wish to avoid full brokerage costs by the exchanges on large transactions. The securities listed on the organized exchanges are traded between large institutional investors through brokers who reduce their fees because of the large volume of trading.

The fourth market, however, is where the trading of securities takes place directly between the buyers and the sellers. This market is essentially a telecommunications network among large institutional investors who are primarily interested in trading large blocks of unlisted stocks.

The benefits of the secondary markets, mainly the organized exchanges, can be explained from (i) the investors' and (ii) the firms' point of view. From the investors' point of view, the benefits can be listed as follows:
  1. They encourage investments in the primary markets. Investors are more willing to buy securities in the primary market when they have the opportunity to sell them in the secondary market.
  2. They provide price stability for the securities.
  3. They provide liquidity. They enable the investors to convert their securities into ready cash by making it easier to sell them at a ready market where the instruments are continuously traded. The price is set by an impersonal market on the basis of the rules of demand and supply, and finding a buyer is also not difficult.
  4. They provide a continuous trading mechanism. h e buyers and the sellers continuously trade in the secondary market.

From the firms' point of view, the benefits can be listed as follows:
  1. The price of the security that the issuing firm sells in the primary market is influenced by the prices in the secondary market. h at is, the investors who buy securities in the primary market will pay the issuing i rm no more than the price that they think the secondary market will set for the security. The higher the security’s price in the secondary market, the higher will be the price that the issuing i rm will receive for a new security and hence the greater the amount of capital it can raise. Conditions in the secondary market are therefore the most relevant to firms issuing new securities.
  2. The availability of the secondary market enables firms to raise capital in the primary market to take advantage of timely investment opportunities. A publicly traded firm in this respect has several distinct advantages over the private equity firm when raising capital. The firms' existing share price forms a base for both the firm and the investors when the new issues are traded. Without a market price, the definitions of terms and a formula for computing the price of a new issue become important. It is much more satisfying to sell at a market price than it is to set an arbitrary price without reference to a market price. Moreover, since a firm with publicly traded stock is required to file audited financial statements that give potential lenders more confidence about the reliability of the financial information, it is easier for these firms to issue debt securities.

The efficiency of the markets, mainly the secondary markets, is a major issue in the finance literature. The focus is on informational efficiency, that is, an efficient market is defined to be the one in which a set of information, which arrives randomly at the market, is fully and quickly reflected in the market prices of securities. For a market to be characterized as an efficient one, it must be characterized by
  1. A large number of rational, profit seeking, risk-averse investors who compete without restriction with each other in valuing future benefits of individual stocks
  2. A sufficient number of industrious, inquisitive, informed, and knowledgeable security analysts who strive to discover profitable investment opportunities by detecting inefficiencies in the market. Their primary function is to remove the inefficiencies and restore the equilibrium between price and value in the market.
  3. Rapid and full dissemination of all relevant information that might affect investors' expectations
  4. Low transaction costs
  5. Fairly continuous and wide trading

The literature distinguishes three levels of information through which the market efficiency is appraised. Within this formal framework, market efficiency can be presented in the following forms:
  1. weak form efficiency if prices fully reflect all historical information about past market behavior; 
  2. semistrong form efficiency if prices fully reflect past market behavior plus other types of publicly available information on the economy, industries, and the companies; and 
  3. strong form efficiency if prices reflect all public and private information. It should be emphasized that the efficiency of the market is especially crucial for optimal allocation of scarce capital for economic development.