Primary Markets vs. Secondary Markets

The buying and selling of financial securities is a complex process that has evolved over many years. Each security represents a claim on the financial resources of a firm. The claim could be an equity claim or a debt-related claim.

When a retail investor looks at the stock market, they see only the market where they transact with other investors. However, a lot of investors do not know where the securities come from? In this article, we will explain the concept of primary markets and the issuance of new securities. We will also explain how each stock and bond market is actually intrinsically made up of two markets viz. the primary market and the secondary market. The similarities and differences between the markets have been explained in detail in the article below.

How are Financial Securities Issued?

Retail investors are familiar with the process of trading financial securities. However, they do not know much about how these securities come into existence. In order to explain how securities come into existence, we need to explain what a primary market is.

A primary market is a market where transactions happen between the issuing corporations and investors. Let’s understand this with the help of an example. If corporation A wants to raise money by selling stock, they create new securities that represent a claim on their assets. These securities are then sold to retail or institutional investors. The key point to be noted is that the money from the sale of securities goes to the company issuing the securities. Therefore, markets, where securities are created and sold for the first time, are called primary markets. Retail investors seldom participate in primary markets. Earlier, most of these securities would be purchased by investment banks and financial institutions behind closed doors. However, now these securities are sold to the larger group of people via initial public offers.

Once the investor has security, they need not hold it till maturity. In the case of equity stocks, there is no maturity at all! Therefore, the market also allows one investor to sell a security to another investor. In this case, the sale proceeds do not go to the company. Instead, they go to the investor that sold the security. Most retail investors are familiar with the process of transacting in secondary markets. Investment banks are not involved in the functioning of the secondary markets. Instead, brokers and dealers intermediate in this kind of market. The difference between brokers and dealers has been explained in a subsequent article.

Functions of the Security Market

The primary market has only one important function. It helps the firm selling securities to raise cash. However, it would be impossible to sell securities in the primary market if the secondary market did not exist. Some of the features of the secondary market have been explained in this article.

• Liquidity: It is important to understand that people buy securities in the primary market since they are sure that they will be able to sell these securities in the secondary market whenever they want. The secondary market creates a system in which the original company does not have to refund money if the investor wants to sell its security. Instead, a different investor can pay the money to the first investor. This allows the first investor to completely walk out of the transaction, leaving the new investor and the company as the parties to the investor. This allows the company to keep the money indefinitely while at the same time, the investor has the liquidity, which allows them to cash out on the transaction.

• Price Discovery: The secondary markets aid the proper functioning of the primary markets. This is because they allow the primary markets to price securities. The investors who buy securities in the primary market only pay the price, which they think they can obtain in the secondary market when they sell the security. Therefore, in the absence of the secondary market, it would be difficult to ascertain what the price of the security should be.

• Dynamic Pricing: Secondary markets also allow securities to be priced dynamically. This means that the prices of securities go up and down depending upon the type of information that the market has about the firm. The market price of the securities fluctuates on a real-time basis. This allows investors to book profits and exit the transactions if required. Also, it is this price in the secondary market, which is an indicator that a company is actually doing well. The management of the company is usually rewarded based on the price signals which the secondary market provides. However, this creates a problem, as well. This is because the price variations in the short run may not necessarily reflect what is best for the firm in the long run.

To sum it up, each securities market is required to have two subsections viz. the primary market and the secondary market. No market can function if it has only one of these markets. Securities markets require constant inflow of newer securities via the primary market and the provisions for trading them via the security market.