Once the securities have been issued in the primary market, they become available for purchase and sale in the secondary markets. There are secondary markets for all kinds of securities, such as stocks, bonds, futures, options, etc.
In the primary market, the investors purchased securities directly from the issuers. However, in the secondary market, the investors purchase these securities from other investors.
There are primarily two types of secondary markets:
- Over-the-counter (OTC) markets
Let us under how both these markets operate.
A stock exchange is a place where stockbrokers and trades trade stocks and other securities.
Usually each country will have atleast one national stock exchange. For example, in the USA, the two major stock exchanges are: the American Stock Exchange (AMEX) and the New York Stock Exchange (NYSE). Apart from that there are several regional exchanges which deal in small local companies.
When you normally trade in stocks or futures, you are actually trading them through a stock exchange, such as AMEX, or NYSE. These exchanges have the following characteristics:
- An exchange provide a centralized place where all trades are conducted
- An exchange plays the key role of acting as the counterparty to all trades. This means is that when you are buying 100 shares of IBM, you are not directly buying it from another party selling those shares. Instead, you are buying it from the stick exchange.
- An exchange removes counterparty risk, because it stands on the other side of all trades.
- Since all the all trades flow through one central place, the price quoted for a security is always the same regardless of who is making the trade. This, in theory, provides a level playing field for all types of investors.
- Exchanges offer greater regulatory oversight, since only members can trade on the exchange, and also only listed products can be traded on an exchange.
Over the Counter (OTC) Market
An OTC market is a decentralized market where non-listed securities are traded by the market participants. There is no centralized place to make the trade. Instead, the market consists of all the participants trading among themselves. Examples of OTC markets are spot forex and many debt markets. This also happens for stocks, and deals are done directly between broker/dealers who make two-way prices to each other in the stocks that they are trading in.
In the US, an example of OTC market is The National Association of Securities Dealers Automated Quotation (NASDAQ). On NASDAQ, the brokers/dealers display their quotes via an electronic system. However, they must directly contact the dealer to get a firm quote and execute the deal.
An OTC market has the following characteristics:
- Since there is no centralized exchange and little regulation, there is heavy competition between different providers for gaining higher trading volume to their firm.
- OTC markets generally have lower transaction costs compared to exchanges
- In OTC markets, the prices for the securities vary from trade to trade and from firm to firm. Even the quality of execution varies from firm to firm. This means that the deals are not always done at the best price.
- OTC markets are prone to counterparty risk because there is no centralized exchange and the parties are directly dealing with each other.