Issuers offer securities to investors in return for capital (money) in the primary market. Companies may need money to hire large workforces, obtain new equipment, or purchase properties. Offering securities (like stock) to investors in the primary market is a common way issuers raise significant amounts of capital.
When a company is in its initial growth stage, it typically raises capital through private placements. This type of offering involves selling securities privately to wealthy individuals and institutional investors. Private placements take place in the primary market and don’t involve much regulator oversight. We will cover these offerings in detail later in the Achievable materials.
If the issuer grows big enough, it will eventually need to raise more capital than it can through private channels. For example, AirBnB Inc. raised capital for years through private placements. The company grew quickly, and in 2020 needed to raise $3.5 billion to continue their expansion. Raising this much money almost always requires the issuer to offer their securities publicly. And that’s precisely what AirBnB did.
The most notable type of primary market transaction is the IPO (initial public offering), which is the first time an issuer makes its stock available to the general public. In December 2020, AirBnB raised $3.5 billion by publicly issuing nearly 52 million shares at $68 per share. Just like private placements, IPOs are also part of the primary market.
When stock is issued publicly for the first time, it could be considered a primary or secondary distribution. Primary distributions occur when a security is sold, and the issuer receives the sales proceeds. For example, AirBnB sells stock in its IPO, and AirBnB (the issuer) receives the sales proceeds from investors.
Secondary distributions occur when a security is sold, but a party other than the issuer receives the sales proceeds. This commonly occurs when officers and directors of an issuer sell shares they’ve acquired through their employment. It also may involve investors liquidating stock they originally purchased through private placements (e.g., a bank that bought AirBnB during a private placement liquidates their shares). If AirBnB’s CEO sold their personally owned shares during the IPO, they would receive the proceeds from the sale (not AirBnB), making it a secondary distribution.
After a stock is sold in the primary market, it trades in the secondary market. There are four subsections of the secondary market:
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. A security could trade in any of these submarkets depending on the characteristics of the transaction.
The first market involves listed stocks trading on stock exchanges. First, let’s define a few things:
You don’t need to know the specifics, but only larger companies with considerable stockholder demand can be listed, especially on prominent exchanges (like the New York Stock Exchange (NYSE)) and NASDAQ. The most prestigious stocks are listed on these exchanges. For example, Walmart Inc. stock is listed on the NYSE. A first market trade occurs if an investor purchases Walmart stock, and the trade takes place on the NYSE. While the NYSE is the primary venue where Walmart stock trades, there are other places investors can buy or sell 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. Although Walmart stock primarily trades on the NYSE, financial organizations outside the exchange also trade Walmart stock with the public. These are known as market makers, who operate in the third market (and the second market, which we’ll discuss below). Market makers do what their name suggests - they make markets. They do so by trading securities directly with the public.
Let’s go through an analogy - think about how a used car dealership works. They buy used cars into their inventory at a marked-down price, then try to sell them at a marked-up price. For example, a dealership buys a used Honda Accord for $6,000 from one customer, then sells it a few weeks later for $10,000 to another customer. The dealership earns the spread - the difference between their buy price (the bid) and sell price (the ask) - $4,000 in our example.
Market makers operate like car dealerships - just replace cars with stocks and other securities. They buy securities from investors at marked-down prices and place them into their inventory. Then, they attempt to sell the securities to other investors at marked-up prices. Market makers are known for “adding liquidity to the market.” The more market makers that exist, the more opportunities for investors to trade a security.
Market makers in the third market give direct competition to exchanges. Before the third market existed, exchanges were the only venues investors could buy or sell stock. When there’s only one place to obtain something, it sure feels like a monopoly. Today, most investor trades are routed to the venue where the best possible price exists. For example, the NYSE may be trading Walmart stock at $150, while a market maker in the third market is trading it for $149. An investor placing a buy order would benefit from buying the stock outside the NYSE (from the market maker in the third market). If the transaction executes, it occurs in the third market - where listed stocks trade OTC.
We skipped the second market, so let’s discuss that now. The second market is where unlisted stocks (stocks not listed on an exchange) trade solely OTC. Not every stock meets the listing requirements to trade on exchanges, which is typical for small or financially distressed companies. Unlisted stocks trade only in the OTC markets.
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, assume Charles Schwab wants to buy 1 million shares of Netflix for one of their funds. 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 in the public markets. If Schwab were to buy 1 million Netflix shares directly from a hedge fund, the trade takes place in the fourth market.
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).
Dark pools are private trading venues, also known as alternative trading systems (ATS), that allow large institutional investors, such as mutual funds, hedge funds, and pension funds, to buy and sell large blocks of securities anonymously. Dark pools are part of the fourth market. Unlike public exchanges, dark pools do not display order information before execution. This means there is no visible data about whether the order is a buy or sell, the size of the trade, or who placed the order. This lack of pre-trade transparency helps institutions avoid market impact, where the visibility of a large order might cause other traders to react and move the price unfavorably.
Once a trade is executed in a dark pool, it must be reported to a Trade Reporting Facility (TRF), and the details are reflected in the consolidated tape, preserving some level of post-trade transparency. Dark pools are registered as broker-dealers and must comply with SEC Regulation ATS. While they provide a way to execute large trades discreetly and with minimal price disruption, they have been criticized for reducing overall market transparency and potentially giving unfair advantages to high-frequency traders.
It’s important to understand that dark pools differ from lit exchanges like the NYSE or Nasdaq, where all orders are publicly visible in an order book. Dark pools offer limited price discovery since quotes are not publicly displayed.
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