Issuers offer securities to investors in return for capital (money) in the primary market. Companies may need money to hire large workforces, buy new equipment, or purchase property. Selling securities (like stock) in the primary market is a common way for issuers to raise large amounts of capital.
When a company is in its early 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 regulatory oversight. We’ll cover these offerings in detail later in the Achievable materials.
If the issuer grows large enough, it may 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 it needed to raise $3.5 billion to continue expanding. Raising that much money almost always requires a public offering - and that’s 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. Like private placements, IPOs are part of the primary market.
When stock is issued publicly for the first time, it can be considered a primary or secondary distribution.
Primary distributions occur when a security is sold and the issuer receives the sales proceeds. For example, if AirBnB sells stock in its IPO, AirBnB (the issuer) receives the proceeds from investors.
Secondary distributions occur when a security is sold but a party other than the issuer receives the sales proceeds. This commonly happens when officers and directors sell shares they acquired through employment. It can also involve investors selling stock they originally purchased through private placements (for example, a bank that bought AirBnB during a private placement later sells those shares). If AirBnB’s CEO sold personally owned shares during the IPO, the CEO would receive the proceeds (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 strange at first, the first market is part of the secondary market - and so are the second, third, and fourth markets. A security can 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 terms:
You don’t need to know the listing requirements in detail, but the key idea is that only larger companies with significant investor demand tend to be listed - especially on major exchanges like the New York Stock Exchange (NYSE) and NASDAQ. For example, Walmart Inc. stock is listed on the NYSE. A first market trade occurs if an investor buys Walmart stock and the trade executes on the NYSE.
Even though the NYSE is the primary venue where Walmart stock trades, it can also trade elsewhere, including 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. More broadly, an OTC trade is any trade that takes place away from an exchange.
Although Walmart stock primarily trades on the NYSE, financial firms can also trade Walmart stock with the public away from the exchange. These firms are known as market makers, and they operate in the third market (and the second market, which we’ll cover shortly). Market makers do what their name suggests: they make markets by trading securities directly with the public.
Here’s a helpful analogy. Think about how a used car dealership works:
For example, a dealership might buy a used Honda Accord for $6,000 and sell it a few weeks later for $10,000. The spread is $4,000.
Market makers operate in a similar way - just replace cars with stocks and other securities. They buy securities from investors (adding them to inventory) and then try to sell them to other investors. This is why market makers are often described as “adding liquidity to the market”: more market makers generally means more opportunities for investors to buy and sell.
Market makers in the third market compete directly with exchanges. Before the third market existed, exchanges were the main venues where investors could buy and sell listed stocks. Today, most orders are routed to the venue offering the best available price.
For example, the NYSE might be trading Walmart stock at $150, while a market maker in the third market is offering it at $149. An investor placing a buy order would benefit from buying at $149. If the trade executes with the market maker, it occurs in the third market - where listed stocks trade OTC.
We skipped the second market, so let’s define it now. The second market is where unlisted stocks (stocks not listed on an exchange) trade solely OTC. Not every stock meets exchange listing requirements, which is common for smaller 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 may prefer to avoid public markets that include many retail (smaller) investors.
For example, assume Charles Schwab wants to buy 1 million shares of Netflix for one of its funds. It’s often easier to buy that many shares from one (or a few) other institutions rather than interacting with hundreds or thousands of smaller orders in public markets. If Schwab bought 1 million Netflix shares directly from a hedge fund, the trade would take place in the fourth market.
The fourth market operates through Electronic Communications Networks (ECNs). You can think of ECNs as electronic bulletin boards where large institutions can post interest in buying or selling large 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).
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 don’t display order information before execution. That means there’s no visible data about:
This lack of pre-trade transparency helps institutions avoid market impact, where other traders react to a visible large order and move the price in an unfavorable direction.
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. This preserves some level of post-trade transparency. Dark pools are registered as broker-dealers and must comply with SEC Regulation ATS. While they can help institutions execute large trades discreetly and with minimal price disruption, they’ve also been criticized for reducing overall market transparency and potentially giving unfair advantages to high-frequency traders.
It’s important to distinguish dark pools from lit exchanges like the NYSE or Nasdaq, where orders are publicly visible in an order book. Dark pools offer limited price discovery since quotes aren’t publicly displayed.
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