Secondary Market : Functions, Types, Instruments & Importance

What is Secondary Market?

Secondary market is defined as a platform where investors buy and sell financial instruments (like stocks, bonds, and other securities). It is also known as the Aftermarket as this is where the second stage of the financial instruments take place after issuing for the first time in the primary market. Here, trading takes place between traders and other investors instead of the entities who issue their securities. Usually, people associate the stock market with the secondary market.

Geeky Takeaways:

• Secondary market trade securities that were earlier sold in the primary market.
• The trade happens among the investors instead of directly selling by the issuing company.
• This market offers liquidity to the investors, facilitating the selling of securities easily and quickly if the investors need money.
• In addition to this, the secondary market allows investors to purchase securities to enhance their portfolio, modify their asset allocation, and hedge against market risks.

Functions of Secondary Market

The secondary market is the platform in which the major chunk of security (stock, shares, etc.) trading takes place. Some of the functions of the secondary market are,

1. Investment: The secondary market is an opportunity for investors to invest in company stocks. Mutual funds, pension funds, bonds, and stocks are all forms of investment that occur in the secondary market.

2. Maintain Liquidity: This market provides liquidity to investors by allowing them to buy or sell existing securities easily and quickly due to a large number of buyers and sellers. This enables continuous and active seamless trading. Due to the function of liquidity, investors can easily generate cash by selling the shares they own.

3. Price Discovery: The market is responsible for determining the fair market value of securities through the forces of demand and supply. If the demand increases, the prices of the securities will rise and if the demand decreases (supply increases), the prices of those securities will fall.

4. Risk Management: Investors can use the secondary market to adjust their portfolios, manage risks, and exit or enter positions. The diversification of the portfolio can be properly maintained in the secondary market reducing the risk. Investors can manage their market risk by hedging their portfolios. The secondary market is exposed to market risk and other economic risk.

5. Low Cost: The transaction cost is lower as a high volume of transactions takes place in the secondary market. Unlike the primary market, the brokers charge a minimal fee apart from the transaction cost which is quite low compared to the commission of underwriters.

How does the Secondary Market Work?

It is known that the secondary market is where the investors are highly involved. They trade securities among themselves. The issuing company has no involvement in this market, only their shares are bought and sold by the investors, brokers, and dealers. They can only monitor the market and control the transactions, so that the management can make well-informed decisions.

The secondary market operates on organised exchanges such as the New York Stock Exchange (NYSE), National Stock Exchange (NSE), and Bombay Stock Exchange (BSE) or via Over-The-Counter (OTC) platforms where trading occurs directly between buyers and sellers. Organised Exchanges or Exchange-traded markets are traded in centralised locations while OTC markets have decentralised locations for trading. In the exchange-traded market, investors put their orders for a subscription via a broker or an online platform dedicated to trading, and then the exchange matches buyers and sellers depending on the prices investors are willing to pay or receive. A clearing house happens to execute such a trade. On the other hand, investors trade directly with the dealers in the OTC market. However, there exists some counterparty risk and less transparency although this OTC trading is more flexible in terms of size and type of securities traded.

The prices of the securities in the secondary market are determined by the market supply and demand. As more investors are interested in buying security (demand increases), then the price of the security tends to rise (booming economy). Conversely, if more investors are willing to sell (supply increases), then the price may go down (deteriorating economy). This dynamic system of pricing assures that the securities are priced efficiently and a fair value of received by the investors for their investments.

Types of Secondary Market

The secondary market or the aftermarket is segregated into multiple categories. Primarily two categories are considered, Stock Exchanges and Over-The-Counter Markets.

1. Stock Exchanges

A centralised platform where securities are traded is known as the Stock Exchange. Investors trade with other investors without knowing them personally. Only the price of the securities matters for either buying or selling them. There are strict regulations given by SEBI (Securities and Exchange Board of India) which the exchanges should follow and should list securities for trading which are trustworthy. Therefore, for investors exchanges are the safest options for trading. The services of stock exchanges can be used by providing a commission and an exchange charge. Examples of stock exchanges are the New York Stock Exchange (NYSE), the Bombay Stock Exchange (BSE), the National Stock Exchange (NSE), NASDAQ, the London Stock Exchange (LSE), the Hong Kong Stock Exchange, and the Frankfurt Stock Exchange.

2. Over-The-Counter (OTC) Market

The OTC market deals with individual investors or participants. It is different from the stock exchange as the OTC market is a decentralised platform. Here, the risk is high as they lack stringent rules and regulations. The competition of investing is high and investors try to accumulate higher volumes of stocks for future trading. This results in price fluctuations among participants. A broker-dealer relationship persists. The stocks of those companies are listed under the OTC market which do not meet the requirements to be listed in the stock exchanges. Examples of OTC markets are FOREX (Foreign exchange), OTCEI (over-the-counter exchange of India), Pink Sheets, OTCQB (Venture Market), etc. The derivative markets are also included in the OTC market. Derivative markets are those where underlying assets or commodities are put as stock (e.g.: oil, rice, coal, etc.).

Importance of Secondary Market

The secondary market is important to an economy due to the following reasons,

• The prices of the stock market depict the economic condition of a nation, either boom or recession. Therefore, it is said to be a good indicator of the economic condition.
• A company can be valued depending on the market forces (supply and demand). The market prices help an investor make better investment decisions.
• Investors can easily convert their investments into cash. The liquidity factor is high in the secondary market.
• A secondary market is a platform where investors can use their idle money to generate some returns.

Different Instruments in the Secondary Market

The aftermarket trades on different instruments can be categorised into three types,

1. Fixed Income Instrument: These types of instruments are investments that generate fixed income or regular income. For instance, the monthly interest and on maturity the principal amount. Debentures and bonds are also a form of fixed-income instruments.

2. Variable Income Instrument: As the name suggests variable, means not fixed. These investments do not guarantee a fixed income, rather the market decides the variable returns. These instruments are highly risky but can generate high returns. Examples include equity and derivatives investment.

3. Hybrid Instrument: Some instruments which provide both fixed and variable returns are termed hybrid instruments. If an investor invests in these forms of instrumentation, then he/she might generate either high or low returns but a fixed amount will always generate. An example of the hybrid instrument is the convertible debenture which is primarily a debt security but can be converted into equity shares after some time.

Advantages of Secondary Market

The secondary market offers numerous advantages for issuers, investors, and the entire financial system. Some of them are mentioned below:

1. Price Discovery: The secondary market ensures price discovery by persuading investors to invest in securities depending on the different market forces (supply and demand). This enables in ensuring that the financial instruments are priced efficiently and it helps in a fair valuation of the company and investors also receive a fair value for their investments.

2. Risk Transfer: In the secondary market, investors can adjust their risk by buying and selling securities. For instance, an investor who owns a share of a company and can speculate on a potential market downturn, the investor can sell his/her ownership to another investor, thereby transferring the risk of that share to the new owner. This enables the investor to adjust their portfolios as required due to this high flexibility in the secondary market.

3. Transparency: The transactions in the secondary market are mostly transparent as information about the issued securities, the issuers and the volume of trading (lot size) are easily available to the investors. This enables investors to be well-informed and they can make the right decisions about their investments.

4. Capital Raising: The secondary market facilitates capital raising as it allows companies to issue new securities to raise funds for their operations. This can be done using the follow-on public offerings or secondary offerings.

5. Liquidity: Mobility of funds is easier which directs about the liquidity of investments. Investors can easily buy or sell previously issued securities. The secondary market makes trading easier for the investors as they can adjust their portfolios subject to the changing market conditions and further, allows them to access money quickly, if required.

Disadvantages of Secondary Market

Apart from having pros of the secondary market, there exist some potential cons which the investors must be aware of:

1. Volatility: The secondary market is highly volatile so the prices of stocks are subject to rapid and unpredictable changes due to market conditions, or investor sentiment, or other factors. This creates uncertainty and makes it difficult to predict the value of the investors’ investments.

2. Market Manipulation: This market is vulnerable to market manipulation as some miscreants might enter for their benefit. There might occur incidents of insider trading or some fraudulent activities, which are capable of distorting the prices and harming true investors.

3. Counterparty Risk: Investors are exposed to the counterparty risk mainly in the OTC market. Counterparty risk occurs when the opposite party in the transaction avoids fulfilling their obligations. In the OTC (over-the-counter) market which is a type of secondary market, there is no centralised exchange party or clearinghouse to guarantee the trade. Hence, this type of risk mostly occurs in the OTC market.

4. Limited Access: Sometimes, in some markets, there will be limited accessibility to investors. For example, only accredited investors or institutional investors will be allowed to invest. Here, individual investors won’t be allowed to access these markets.

5. Price Discrepancies: In the secondary market, the price of a stock or bond might not accurately resemble its underlying value or opportunities. This can create price discrepancies and misalignments between market prices and fundamental financials.

Difference Between Secondary Market and Primary Market

Basis	Secondary Market	Primary Market
Purpose	Involves the trading of existing securities among investors.	Involves the issuance of new securities.
Function	Investors buy and sell previously issued stocks or bonds.	Companies raise capital by selling newly issued stocks or bonds.
Participants	Brokers, Investors, and Dealers.	Underwriters, Investors, and Issuing companies.
Price	Market-driven price based on market fluctuations.	Fixed price determined by the underwriters.
Volume	A high volume of shares are transacted.	A low volume of shares are issued.
Regulated by	Regulated by SEBI and other stock exchanges.	Solely regulated by the SEBI.