What is Secondary Market: Types and Functions

Secondary markets also help determine the market price for securities, reflecting their perceived value based on supply and demand. These markets provide liquidity to investors, allowing them to easily buy and sell securities based on investing needs and objectives.

Over the course of this article, we will be discussing the details of secondary market in detail.

Table of Content

• What is secondary market?
• Types of secondary market
• Trading mechanisms
• Functions of secondary market
• Key participants
• Regulations followed

What is secondary market?

A secondary market is a financial market where previously issued financial instruments are traded. Investors trade in securities that have already been traded in the primary market. Instead of the original issuing identity, investors are freely involved in trading within the secondary market. 

Unlike the primary market, the original issuers of the securities do not participate in the transactions of the secondary market. Instead, the transactions take place between investors, facilitated by intermediaries such as stock exchanges, brokerage firms, and investment banks. 

Types of Secondary Markets

Following are the types of secondary markets based on trading mechanisms and the structure of the market:

• Auction Market: In an auction market, buyers and sellers submit their bids and offers for securities, and transactions are executed at a mutually agreed-upon price. This price is typically determined through a process known as an auction, where the highest bid price is matched with the lowest ask price. Auction markets are characterized by a centralized and transparent price discovery process. The New York Stock Exchange is a type of auction market.
• Dealer Market: In a dealer market, also known as the over-the-counter (OTC) market, transactions are executed through a network of dealers who act as market makers. These dealers quote, bid and ask prices for securities and stand ready to buy or sell them. Unlike auction markets, dealer markets do not have a centralized location or a single price discovery mechanism. Instead, trades are executed through a decentralized network of dealers who maintain their own inventory of securities. The NASDAQ Stock Market and the OTC Markets Group are examples of dealer markets.
• Stock Market: A secondary market where shares of publicly traded companies are bought and sold. Stock markets can be further divided into large-cap, mid-cap, and small-cap markets, based on the market capitalization of the listed companies.
• Bond Market: A secondary market where debt securities, such as government and corporate bonds, are traded. Bond markets can be further classified into government bond markets, municipal bond markets, and corporate bond markets, depending on the type of issuer.
• Derivatives Market: A secondary market where financial instruments, such as options, futures, and swaps, are traded. Derivatives markets can be further divided into exchange-traded derivatives markets, which operate through centralized exchanges, and over-the-counter derivatives markets, which operate through a network of dealers.
• Foreign Exchange Market: A secondary market where currencies are bought and sold. The forex market is primarily an over-the-counter market, with transactions taking place through a global network of banks, financial institutions, and other participants.

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Trading Mechanisms

The below-given trading mechanisms are followed in the secondary markets:

1. Electronic Trading Platforms: With the advancements in technology, electronic trading platforms have become the primary method of trading in secondary markets. These platforms enable investors to trade securities through computerized systems, ensuring faster execution, reduced costs, and improved accessibility for investors.
2. Algorithmic Trading: Algorithmic trading involves the use of computer algorithms to execute trades in this market. These algorithms analyze market data and execute trades based on pre-defined rules, often with minimal human intervention. Algorithmic trading has increased the speed and efficiency of trading in secondary markets.

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Functions of the Secondary Market

The following functions are crucial in a secondary market:

• Liquidity: One of the primary functions of this market is to provide liquidity to investors. By offering a marketplace for buying and selling securities, it allows investors to easily convert their investments into cash whenever needed. This liquidity enables investors to manage their investment portfolios more efficiently and reduces the risk of holding assets that cannot be easily liquidated.
• Market Efficiency: Secondary markets contribute to the overall efficiency of financial markets. By enabling the transfer of securities from less to more efficient investors, these markets promote the optimal allocation of capital. Efficient secondary markets also ensure that the prices of securities accurately reflect all available information, minimizing the potential for arbitrage opportunities.
• Price Discovery: The secondary market is essential for determining the market price of securities. Through the interaction of buyers and sellers, the perceived value of a security is established based on its supply and demand. This price discovery mechanism helps investors make informed decisions about their investments and reflects the overall health of the financial market.

Key Participants in the Secondary Market

The following players compose a secondary market:

• Stock Exchanges: London Stock Exchange (LSE) and New York Stock Exchange (NYSE) or types of organized marketplaces where securities are traded. They provide a transparent and regulated platform for investors to trade securities and ensure that transactions are executed according to established rules.
• Brokerage Firms: Brokerage firms act as intermediaries between buyers and sellers in the secondary market. They facilitate transactions by executing trades on behalf of their clients and may also provide additional services, such as investment advice or research. Brokerage firms earn revenue through commissions on the trades they execute.
• Market Makers: Market makers are financial institutions that continuously offer to buy and sell securities at specified prices, thereby ensuring liquidity in the market. By standing ready to trade, market makers narrow the bid-ask spread and help maintain an orderly and efficient market.
• Institutional and Retail Investors: Institutional investors, such as mutual funds, insurance companies, pension funds, as well as retail investors, actively participate in the secondary market. Their trading activities influence the supply and demand dynamics of the market and contribute to price discovery.

Regulations Followed

The following regulations are followed in the secondary market:

1. Regulatory Authorities: Secondary markets are subject to regulation by various authorities, including the Securities and Exchange Commission (SEC) and Financial Conduct Authority (FCA) in the United Kingdom. These regulatory bodies ensure that the markets operate in a fair, transparent, and orderly manner, protecting the interests of investors.
2. Investor Protection Mechanisms: To safeguard investors, secondary markets have several investor protection mechanisms in place, such as the requirement for companies to disclose financial information, the enforcement of trading rules, and the establishment of investor compensation schemes in case of broker default.