After a security is sold for the first time in the primary market, it begins trading in the secondary market. At that point, the issuer has already raised capital, and investors trade the security with other investors at its current market price. The secondary market has its own participants, rules, and trading venues.
In this section, you’ll see 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 want to know:
Traders are natural persons (human beings) or entities (businesses or organizations) that buy and sell securities on behalf of their clients. In practice, traders usually don’t speak with or maintain relationships with those clients.
For example, many mutual funds employ several (or even dozens of) traders to carry out the fund manager’s strategy. The fund manager sets and adjusts the strategy, and the traders execute it by buying and selling securities for the fund. Traders working for large portfolios (like mutual funds) generally don’t maintain relationships with the investors in those 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 terms, broker-dealers help customers trade securities and earn profits by doing so. They can operate in one of two capacities: agency or principal. The difference between these capacities is covered later in this review (see below).
Here’s a list of the 5 largest broker-dealers in 2020:
Traders and broker-dealers can sound similar because both are involved in buying and selling securities. A key difference is that broker-dealers typically maintain client relationships, while traders usually don’t.
If you have an account at a broker-dealer, you’re often offered services like retirement planning, portfolio analysis, and cash management. Relationship management matters because competition is high and assets can be moved quickly from one broker-dealer to another. Traders, by contrast, are usually focused solely on executing trades as part of a larger portfolio operation.
Market makers are financial organizations that buy and sell securities solely on a principal basis (from inventory) to traders, broker-dealers, and other public customers. They continuously quote bid and ask prices (see below), which are the prices they’re willing to trade at. Market makers are important because they provide liquidity - making it easier for others to buy and sell.
In an efficient market, bid-ask spreads tend to be narrow because trading volume is high and competition among dealers is strong. In that environment, dealers can still earn profits without quoting wide spreads. If a market maker quoted unusually large spreads in a highly competitive market, they would likely lose business to other dealers offering better prices.
The last few paragraphs use a lot of market vocabulary, so here’s the same idea in plain terms. Imagine you have a large inventory of apples. You set up a stand with a sign that says:
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, which makes you an apple market maker.
Because you’re always ready to buy or sell, it becomes easier for others to trade apples. That’s 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 earn profits by quoting bid and ask prices. If you place a trade with a broker-dealer*, the firm will often route your order to a market maker, who fills the order. For many publicly traded stocks (especially those listed on exchanges), there are dozens of market makers competing. Traders and broker-dealers seek out the best available prices to maximize results 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 earn money by trading with the public in the secondary market. Depending on the security and the firm’s role in the transaction, a firm 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, it works to match the customer’s order with another participant in the market.
On any given day, thousands of trades occur in IBM, so it typically won’t be difficult to find someone willing to sell 100 shares. The trade goes through once the firm finds a seller who meets the customer’s price and other trade specifications.
When a firm matches an order on an agency basis, it collects a commission. In other words, the firm is acting as a middleman. This is similar to other types of brokers. For example, real estate brokers match buyers with sellers and charge a commission when a transaction occurs.
Now compare that with a principal transaction. If the firm acts in a principal capacity, it sells the shares out of its own inventory. As discussed earlier, market makers always act in a principal capacity. They make themselves available to the public and are willing to buy and sell securities with customers:
Firms acting in a principal capacity earn money through mark-ups and mark-downs. This is similar to how dealers operate in other markets. For example, a used car dealership buys cars from the public at prices below their market value. If you sell your car to a dealership and receive less than market value, that difference is a mark-down. The dealership then tries to sell the car at or above market value, which is a mark-up. The basic idea is the same: dealers aim to buy low and sell high.
Acting in a principal capacity involves risk because the value of securities held in inventory can drop. If that happens, the firm may have to sell at lower prices and take a loss.
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 trading for a stock. Like an auctioneer, the DMM matches buyers with sellers, and it may also trade with the public out of its own inventory. In a given trade, the DMM can operate in an agency or principal capacity.
The NYSE trades only stocks that are “listed” on the exchange. To be listed, issuers must meet certain characteristics, such as market capitalization and minimum numbers of shareholders. You don’t need to memorize the listing requirements, but you should know that the NYSE generally trades large companies with actively traded stocks.
In addition to the NYSE, many other exchanges function similarly. For example, the American Stock Exchange, referred to as NYSE-MKT, is also a large national exchange. There are also regional exchanges, such as the Philadelphia Stock Exchange. A stock may trade on the NYSE and another exchange (typically a regional one). These are called dual-listed stocks.
Securities transactions are categorized by the venue where they occur. Any trade that takes place on the NYSE is a first market transaction, meaning a listed stock is traded directly on an exchange.
Market makers can also trade NYSE-listed securities outside the NYSE. For example, an investor might purchase Coca-Cola stock (ticker: KO) directly from a market maker* offering KO at a slightly better price than the NYSE. That would be 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 into one of the largest exchanges in the world.
Unlike the NYSE’s auction market structure, NASDAQ is a negotiated market. Instead of one centralized DMM facilitating all trades in a stock, dozens of market makers compete to trade with the public. The market makers quoting the best prices tend to receive the most order flow.
Market makers trade only in a principal capacity, similar to used car dealerships:
If you imagine dozens of dealerships competing, you have a good analogy for NASDAQ: replace dealerships with market makers and cars with stocks.
NASDAQ is considered an over-the-counter (OTC) market because it doesn’t have a physical trading floor. However, NASDAQ still has “exchange status,” and its stocks are treated as exchange-listed. Like the NYSE, NASDAQ has high standards for listing.
NASDAQ is open daily from 9:30am - 4:00pm ET for normal operating hours, the same as the NYSE. It also offers pre-market and post-market trading.
NASDAQ after-hours
Pre- and post-market trading increases trading opportunities, but it also adds risk. Fewer investors trade during these hours, which can increase volatility. Many broker-dealers require customers to review a risk disclosure before trading in these sessions. Key risks include wider spreads, lower trading volume, and higher volatility.
The NYSE and NASDAQ used to regulate their own markets as self-regulatory organizations (SROs). SROs are granted regulatory power and oversee participants in their markets. In 2007, the NYSE’s and NASDAQ’s regulatory arms combined into FINRA, 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 doesn’t meet the listing standards of the NYSE, NASDAQ, or other exchanges, it may trade only in the non-NASDAQ over-the-counter (OTC) markets. There are two large markets to know in this part of the secondary market.
The OTCBB (OTC Bulletin Board) and OTC Pink are two large markets where non-listed stocks trade. OTC Pink is sometimes called the Pink Sheets, a name that comes from how quotes were originally printed on pink 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 exchange listing standards, its securities trade in these smaller, less efficient markets. Trades in these markets are considered second market transactions.
Now that we’ve covered the main subdivisions of the secondary market, here’s a summary:
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