Every nation’s financial system comprises of business entities that constantly require funds to finance their operations as well as investors who are looking out for avenues to gainfully invest their funds. The capital market is where both companies and investors are brought together to trade by way of issue and trade of securities – be it equity based instruments such as stocks or debt based instruments such as bonds and debentures. Every capital market is primarily bifurcated into two stages – the primary market and secondary market.
The article “primary market vs secondary market” looks at meaning of and differences between these two basic types of security markets.
Definitions and meanings
The primary market of securities (some time referred to as new issues market) is the first market level at which tradeable securities originate and are directly sold to investors by the issuing entities. The primary market transactions directly flow cash into the issuing companies and contribute much of their capital to start and continue operations.
Companies can directly issue their shares to investors by means of private placement or initial public offering (IPO). Debt securities such as bonds and debentures can also be directly subscribed to from the company in the primary market. Primary market transactions largely consist of the following:
- Subscription to shares of a company by the public, through IPO: When a company decides to raise funds from the public, it offers its shares to the public through an IPO. When public investors take up this offer and subscribe to the shares directly from the issuing company, the transaction is considered as primary market transaction.
- Subscription to shares of a company by underwriters: When a company decides to offer its shares to the public through an IPO, it may engage an underwriting firm who will commit to subscribing to any shares that have not found buyers in the IPO. This also qualifies to be a primary market transaction.
- Allotment of right and bonus shares: Profitable companies may announce issue of bonus shares to its existing shareholders. They may also offer right shares to its existing shareholders who have the first right to subscribe to fresh issue of shares.
- Private placement of securities: Companies may offer its securities to large established investors such as banks and mutual funds. Companies can opt for this when they wish to raise large amounts of money without offering their securities to the general public at large.
The secondary market is the subsequent market level in which securities are bought and sold amongst investors. After investors subscribe to shares or purchase other securities of a company through a primary market transaction, they may offer these securities for subsequent sale to other investors. This trade takes place between two or more investors directly without any direct and active involvement of the issuing company.
For example, you own 1,000 shares of Walmart and you want to sell them to meet some immediate cash needs. You can’t go to Walmart to sell these shares, there exists an active market for this purpose. Just go to a stock exchange like NYSE and sell them to another investor who is already looking for Walmart shares. Similarly, if you want to buy Microsoft stock, you will have to deal with another investor who owns Microsoft shares and want to sell them. In both the cases, you are not directly dealing with the issuing companies (i.e., Walmart and Microsoft) but with buyers and sellers in a stock market. Both are thus examples of secondary market transactions.
Due to the involvement of a larger number of traders and investors, the transaction volume in secondary markets is typically much higher than the primary markets, in terms of both numbers and dollar values.
Secondary market transactions typically take place in the form of either market based or over-the-counter transactions.
- Market based transactions are those trades that take place through registered stock exchanges across the world. This is highly organized form of securities trade. Stock trades taking place in New York Stock Exchange (NYSE), Nasdaq and London Stock Exchange (LSE) are examples of market based transactions. In order to save the interest of investors and traders and to protect them from fraud, countries have regulatory bodies in place that strictly regulate and monitor the activities of these financial or capital markets. Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) are the examples of regulatory bodies that serve this purpose in USA.
- Over-the-counter (OTC) transactions are those trades of securities that do not take place across an organized stock market but privately between two or more investors. Due to the absence of a centralized exchange, OTC transactions are prone to a significant counterparty risk. These transactions occur primarily in case of unlisted companies and their volume is significantly lower than the market-based transactions.
Difference between primary market and secondary market:
The difference between primary market and secondary market have been detailed below:
- Primary market is the market where fresh issue of company securities are created, offered and sold for the first time by the issuing company. It provides the first opportunity that investors can avail to subscribe to a company’s stock.
- Secondary market is the market where pre-issued securities are traded amongst investors.
- Primary market is the first stage at which equity and debt securities are created and sold to investors.
- Secondary market is the subsequent stage at which securities created in the primary market are traded further.
3. Transacting parties
- In the primary market, the seller is the company who is issuing securities whereas the buyer is an investor. A major portion of the funds collected via this market flows to the issuing entity.
- In the secondary market, both seller and buyer are investors. Most of the funds flow between investors who buy and sell securities.
4. Securities traded
- In the primary market, only new or freshly issued shares and bonds are exchanged.
- In the secondary market, existing securities like shares, debentures and bonds etc. are re-traded
- In the primary market, underwriters are often engaged by the issuing company during initial public offering (IPO) to assist in the completion of the trade.
- In the secondary market, brokers function as facilitator and intermediary between the buyer and seller.
- The purpose of primary market transactions is to raise funds for the issuing company by way of subscription to its share capital or borrowing money against issue of bonds or debentures.
- The purpose of secondary market transactions is investments based – generally to earn profits through buying and selling securities.
- The price of issued securities in the primary market are fixed and decided by the issuing company.
- The price of securities traded in the secondary market are not fixed and fluctuate with each trade. They are generally guided by market demand and supply factors.
8. Legal formalities
- The sale of securities on the primary market generally require extensive legal formalities to be completed by the issuer. This is because these securities are created in this market.
- The sale of securities on the secondary market require lesser legal formalities and compliances as it involves only re-trading of pre-existing securities.
9. Frequency of trades
- Fewer amount of trades take place in the primary market i.e., only when large scale funding requirements arise for the issuing company.
- Higher volume of trades take place in the secondary. In fact, the same securities can be traded daily and, in many cases, several times within the same trading day.
- Examples of primary market transactions include IPOs, bonus and right share issues, private placement, preferential allotment etc.
- Examples of secondary market includes almost all stock exchanges such as NYSE, Bombay Stock Exchange, Tokyo Stock Exchange Nasdaq etc.
Conclusion – primary market vs secondary market:
Both primary and secondary market trades involve cash inflow and outflow at significant volumes. These markets form the base of the capital market which is the core of any country’s financial system. The trade level at both these markets reflects the financial health of a country’s economy. Each country thus drafts laws and policies and engages regulators who are empowered to regulate transactions across both these markets.