When a company decides to raise money by offering its stock to investors, it first sells 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 its shares to the general public.
Many companies are fairly large and successful by the time they go through an IPO. However, to scale (grow) the business, a company may need significant amounts of money to build new offices, purchase equipment, or hire employees.
When a company sells its stock in an IPO, it does so for one main reason: to raise money. Stockholders gain some control over the direction of the company, so the company is giving up some control in exchange for capital.
When stock is sold to the public for the first time, it can 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 sold to the public, but the shares have been previously owned by a party other than the issuer. This commonly happens when officers and directors of an issuer sell shares they’ve acquired through their employer (the issuer). In that case, the shares are sold to a new public owner and the proceeds go to the officer or director (not the issuer).
After shares are sold publicly, they trade in the secondary market, which is often referred to as the stock market. The secondary market is divided into four subsections:
Although it sounds strange, the first market is part of the secondary market - and so are the second, third, and fourth markets. Depending on the characteristics of the stock and other factors, a trade could occur in any of these markets. You’ll want to know the basics of each for the exam.
The first market is where listed stocks trade on stock exchanges. First, let’s define a few terms:
You don’t need to know the specifics of each exchange, but it’s important to know that only larger companies with enough investor demand can be listed - especially on larger exchanges (like the NYSE). In general, 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 takes 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 can also trade in the over-the-counter (OTC) market.
If you handed your friend money in return for their shares of Walmart stock, that would be an OTC trade. An OTC trade is any trade that takes place away from an exchange.
Even though Walmart stock primarily trades on an exchange (the NYSE), there are firms that aren’t associated with the NYSE that buy and sell Walmart stock with the public. These firms are known as market makers, and they operate in the third market.
Without going into too much history, the third market was created decades ago to provide competition to exchanges. Before the third market existed, exchanges were the only place an investor could buy or sell stock. Today, there are usually many places a stock can be bought and sold. Bottom line: the third market is where listed stocks trade OTC.
We skipped the second market, so let’s cover that now. Not every stock meets the listing requirements to trade on exchanges, and exchanges aren’t the only place where stocks trade. Unlisted stocks trade only in the OTC markets because they don’t trade on exchanges. In a future section, we’ll dive deeper into the OTC markets, but for now you can treat an OTC trade as a non-exchange trade.
The fourth market is where large institutions trade without brokers. If a large institution wants to trade stock, it may prefer to avoid the public stock markets, which include many retail (smaller) investors. For example, if Charles Schwab wants to buy 1 million shares of Netflix stock, it’s often easier to buy those shares from one (or a few) other institutions rather than dealing with hundreds or thousands of smaller orders.
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 they match buyers and sellers while collecting a commission; we’ll learn more about agency-based transactions in the secondary market chapter).
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