After a security is sold for the first time in the primary market, it then trades in the secondary market. The issuer raised capital (money), and now stockholders trade the security with other investors at its market price. There are various roles, rules, and dynamics in the secondary market that we’ll discuss in this chapter.
In this section, we’ll detail these secondary market topics:
The Securities Exchange Act of 1934 governs the secondary market and its participants. In general, there are three participants (roles) you’ll need to be aware of:
Traders are natural persons (human beings) or entities (businesses or organizations) that buy and sell securities on behalf of their clients. However, traders rarely speak with or maintain relationships with clients. For example, many mutual funds employ several or dozens of traders to fulfill the strategy of the fund manager. The fund manager may create and adjust the fund’s strategy, but traders execute the strategy by buying and selling securities for the fund. Traders that work for large portfolios (like mutual funds) generally do not maintain relationships with their clients (those who invest in the portfolios).
Previously in this material, we discussed what a broker-dealer is and what they do. As a reminder, broker-dealers are financial firms in the business of performing securities transactions on behalf of others (broker/agency) or for their own account (dealer/principal). In plain English, broker-dealers help their customers trade securities and make a profit doing so. They can operate in one of two capacities: agency or principal. The differences between the two capacities is discussed later in this review (see below).
Here’s a list of the 5 largest broker-dealers in 2020:
While traders and broker-dealers sound similar, broker-dealers tend to maintain relationships with their clients, while traders do not. If you currently have an account at a broker-dealer, you’re probably offered various services like retirement planning, portfolio analysis, and cash management. Relationship management is an important part of a broker-dealer’s business model due to competition and ease of moving assets (it’s very quick and easy to move assets from broker-dealer to broker-dealer). On the other hand, traders simply trade for their clients usually because it’s their sole job as a part of a large portfolio.
Market makers are financial organizations that buy from and sell securities solely on a principal basis (with inventory) to traders, broker-dealers, and other public customers. These organizations maintain ongoing bid & ask spreads (see below), which are prices they’re willing to trade securities at. Market makers serve a very important function in the financial markets as they provide much-needed liquidity for the securities they trade.
The last paragraph is full of financial lingo, so let’s discuss the topic in plain terms. Assume you have a large inventory of apples (for whatever reason). If you put an apple stand in front of your house with a sign that said:
I will buy or sell apples with anyone who is willing to do so. You can sell an apple to me for $1, or you can buy an apple from me for $2.
You’re willing to trade apples with anyone who wants to buy or sell apples, which makes you an apple market maker. The $1 apple quote is your bid (the price you’re willing to buy apples at) and the $2 apple quote is your ask (the price you’re willing to sell apples at). Your presence in the neighborhood makes it very easy to buy and sell apples, which is another way of saying apple liquidity is high. If there are multiple apple market makers in your city, liquidity would be even higher.
Now, replace apples with securities. Market makers buy and sell securities with the public and make a profit doing so. They maintain bid and ask prices (discussed in more detail below) which enable profits, while adding liquidity to the market. If you place a trade with a broker-dealer*, the firm is most likely to send your trade to a market maker, who then fulfills the trade request. With most publicly traded stocks (especially those that are listed on exchanges), there are dozens of market makers trading the security. Traders and broker-dealers seek out market makers with the best possible price to maximize returns for their clients.
*When investors place trades with broker-dealers, most trades are fulfilled on an agency basis. In this scenario, the broker-dealer connects the investor with a market maker and charges a commission. Broker-dealers have the structure and capacity to act as principals, usually in one of two ways. First, they can act as market makers and trade with the public on a principal basis. Second, they act as dealers while taking part in underwriting syndicates.
Financial firms like broker-dealers make money trading with the public in the secondary market. Depending on the security traded and its role in the market, financial firms may trade on an agency or principal basis.
Assume a customer approaches a financial firm and wants to buy 100 shares of IBM stock. If the firm acts in an agency (agent) capacity, they work to match the customer’s order with another participant in the market.
On any given day, thousands of trades occur in IBM, so it shouldn’t be difficult for the firm to find someone willing to sell 100 shares of IBM. Depending on the price and trade specifications requested by the firm’s customer, the trade goes through when the firm finds a seller meeting those specifications.
When a firm matches an order on an agency basis, they collect a commission. In essence, a firm is acting as a middleman. You’ve probably heard of several different types of brokers in the world, all of which act in an agency capacity. For example, real estate brokers match buyers with sellers and charge a commission when a real estate transaction occurs. This is no different than how it works in finance.
How would our customer’s request to buy 100 shares of IBM stock work differently? If the firm acts in a principal capacity, they sell the shares out of their inventory. As we discussed earlier, market makers always act in a principal capacity. They open themselves up to the trading public and are willing to buy and sell securities with their customers. When a customer wants to purchase a security, the market maker sells the security out of their inventory. When a customer wants to sell a security, the market maker buys the security and places it into their inventory.
Firms acting in a principal capacity make money through mark-ups and mark-downs. You’ve heard of different types of dealers in the world, all of which act in a principal capacity. With a used car dealership, cars are bought from the public at prices lower than their market value. You may have experienced this yourself if you’ve sold your car to a dealership. When they buy your car below its market value, this is known as a mark-down. Next, the dealership attempts to sell the car at or above its market value, which is known as a mark-up. Essentially, dealers are trying to buy low and sell high, just like every other investor.
Acting in a principal capacity involves risk, as the value of the securities in the firm’s portfolio could drop drastically. If this occurs, they’ll lose money as they try to sell the security at lower prices.
Here’s a video breaking down a practice question on this topic:
Functioning in some form since 1792, the New York Stock Exchange (NYSE) is the world’s largest stock exchange. The NYSE operates as an auction market, where a designated market maker (DMM) (sometimes referred to as the ‘specialist’) facilitates all trading for a stock. Similar to how any other auction works, the DMM (auctioneer) matches buyers with sellers, but also trades with the public out of their inventory. In any given trade, they can operate in an agency or principal transaction.
The NYSE only trades stocks that are “listed” on the exchange. To be listed, issuers must meet certain characteristics, like market capitalization and minimum numbers of shareholders. You don’t need to know these listing requirements, but you should be aware that only the largest companies with the most actively traded stocks are traded on the NYSE.
In addition to the NYSE, there are many other exchanges that function similarly. There’s the American Stock Exchange, referred to as NYSE-MKT, which is also a large national exchange. Additionally, there are regional exchanges that are similar to the NYSE, like the Philadelphia Stock Exchange. It’s possible that a stock may trade on the NYSE and another exchange, typically a regional one. These are referred to as dual-listed stocks.
Securities transactions are categorized based on the venues they take place in. Any trade that takes place on the NYSE is considered a first market transaction, which occurs when a listed stock is traded directly on an exchange. Market makers can also trade listed NYSE securities outside of the NYSE. For example, an investor purchases Coca-Cola stock (ticker: KO) directly from a market maker* that was offering KO stock at a slightly better price than the NYSE. This would be known as a third market transaction.
*Broker-dealers take transaction requests from their clients and route the orders to the venue with the best possible price, known as the national best bid or offer (NBBO).
Originally started in the 1970s as an association of dealers, NASDAQ grew to be one of the largest exchanges in the world.
Unlike the auction market status of the NYSE, NASDAQ is considered a negotiated market. Instead of a centralized designated market maker (DMM) facilitating all trades in a stock, there are dozens of market makers trading with the public. The market makers with the best prices get the most business.
Market makers trade only in a principal capacity, similar to used car dealerships. People sell their used cars to the dealership at a marked down price. The dealer places the car into its inventory, then aims to re-sell the car back to the public at a marked up price. If a sale occurs, they make the spread (difference between the price the car was purchased for versus what it was sold for). Now, assume there are dozens of these dealerships for the purposes of this analogy. Replace the used car dealership with a market maker and the cars with stocks, and you basically have the NASDAQ system.
NASDAQ is considered an over-the-counter (OTC) market due to the fact that it lacks a physical trading floor. However, NASDAQ is still considered as having “exchange status,” and all of its stocks are treated as if they’re exchange listed. Just like the NYSE, NASDAQ has high standards for stocks being listed on its platform.
The NYSE and NASDAQ used to regulate their own markets as self-regulatory organizations (SROs). SROs are granted regulatory power and oversee the participants in their markets. In 2007, NYSE’s and NASDAQ’s regulatory arms formed into FINRA, which is the SRO that now supervises both markets. Although FINRA is not a governmental entity, it has the power to control who operates in the financial markets and how financial firms interact with the investing public.
When a stock does not meet the listing standards of the NYSE, NASDAQ, or any of the other exchanges, it will trade solely in the non-NASDAQ over-the-counter (OTC) markets. There are two large markets to be aware of in this subsection of the secondary market.
The OTCBB (OTC Bulletin Board) and OTC Pink are two large markets where non-listed stocks trade. OTC Pink, sometimes referred to as the Pink Sheets, has a name that refers back to how their stock quotes were originally printed on pink sheets of paper.
The Over-The-Counter Bulletin Board (OTCBB) was shut down by FINRA in November 2021, and is not part of the OTC Markets Group.
When an issuer doesn’t meet the standards to be listed on an exchange, their securities will trade in these smaller, less efficient markets. Trades in these markets are considered second market transactions.
Now that we’ve discussed subdivisions of the secondary market, let’s summarize them:
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