The primary & secondary market

When a company decides to raise money by offering its stock to investors, it will first sell the security in the primary market. The most notable type of primary market transaction is the IPO (initial public offering), which is the first time an issuer sells their shares to the general public.

Many companies are fairly large and successful by the time they go through their IPO. However, in order to scale (grow) their business, significant amounts of money may be required to build new offices, purchase necessary equipment, or hire the right employees.

When a company sells its stock in an IPO, it does that for one reason - to raise money. Remember, stockholders have some control over the direction of the company. Why else would a company give up control over its business?

When stock is sold to the public for the first time, it could be considered a primary or secondary distribution. If a sale of securities occurs and the proceeds go to the issuer, it’s a primary distribution. In an IPO (a type of primary distribution), the issuer sells its stock to the public for the first time and collects the proceeds from the sale.

A secondary distribution occurs when stock is being sold to the public, but the shares have been previously owned by a party other than the issuer. This commonly occurs when officers and directors of an issuer sell shares they’ve acquired through their employer (the issuer). When this occurs, the shares are sold to a new public owner and the proceeds are collected by the officer or director (not the issuer).

After shares are sold publicly, they then trade in the secondary market, which is often referred to as the stock market. The secondary market is divided into four subsections:

• First market
• Second market
• Third market
• Fourth market

Although it sounds bizarre, the first market is part of the secondary market. Same with the second, third, and fourth markets. Depending on the characteristics of the stock and a few other factors, a stock trade could occur in any of these markets. You must understand the basics of these markets and what they are for the exam.

The first market is where listed stocks trade on stock exchanges. First, let’s define a few things:

You don’t need to know the specifics, but only larger companies with stockholder demand can be listed, especially on the larger exchanges (like the NYSE). The most prestigious stocks are listed on exchanges.

Walmart stock, for example, is listed on the NYSE. A first market trade occurs if an investor purchases shares of Walmart stock and the trade took place on the NYSE. While the NYSE is the primary place where Walmart stock trades, it’s not the only place investors can trade it. Walmart stock also trades in the over-the-counter (OTC) market.

If you handed your friend some money in return for their shares of Walmart stock, it would be an OTC trade. An OTC trade is any trade that takes place away from an exchange. Walmart stock primarily trades on an exchange, specifically the NYSE. However, there are firms that aren’t associated with the NYSE that buy and sell Walmart stock with the public. These are known as market makers, who operate in the third market.

Without going into too much history, the third market was created decades ago to provide competition to exchanges. Before they existed, exchanges were the only place an investor could buy or sell stock. When there’s only one place to obtain something, it sure feels like a monopoly. Today, there are usually dozens of places a stock can be bought and sold (thanks to the third market). Bottom line: the third market is where listed stocks trade OTC.

We skipped the second market, so let’s discuss that now. Not every stock meets the listing requirements to trade on exchanges, but exchanges aren’t the only place where stocks trade. Unlisted stocks only trade in the OTC markets because they don’t trade on exchanges. In a future section, we’ll dive further into the OTC markets, but you’ll only need to assume an OTC trade is a non-exchange trade for now.

The fourth market is where large institutions trade without brokers. If a large institution wants to trade stock, it’s probably best that they avoid the stock markets which are full of retail (smaller) investors. For example, if Charles Schwab wants to buy 1 million shares of Netflix stock, it’s easier to buy these shares from just one or just a few other institutions versus dealing with hundreds or thousands of smaller retail investors.

The fourth market operates through Electronic Communications Networks (ECNs). Think of these as electronic bulletin boards where large institutions can offer to buy or sell significant amounts of stock. ECNs are open 24 hours a day and act on an agency basis (meaning it matches buyers and sellers while collecting a commission; we’ll learn more about agency-based transactions in the secondary market chapter).