Secondary Market: Meaning, Functions, Types and Importance

What Is the Secondary Market?

The secondary market is a marketplace where financial assets such as stocks, bonds, and debentures are traded among investors without any intervention of the company that had previously issued such financial assets. The secondary market, also known as the aftermarket, is different from the primary market since the latter involves the issuance of new securities by issuing companies, and the former involves trading of such issued securities.

But why are the secondary markets called ‘secondary’? The answer is quite simple and straightforward. Secondary market transactions take place at the second stage of the process. Typically, when companies go public by launching an IPO, it is the first instance when new securities are created by the company to be issued to the investors in the market. Once these newly created securities are in circulation, investors can engage in buying and selling these securities. The underlying purpose of making a primary issuance is raising capital for companies, whereas secondary market transactions do not involve companies at all. Rather, the sale and purchase of securities generate income for the investors.

These transactions take place on organised platforms like the National Stock Exchange of India (NSE) and the Bombay Stock Exchange (BSE) in India or through over-the-counter trading platforms.

Functions of Secondary Market

We now understand that secondary market transactions do not involve issuing companies; therefore, investors can freely trade in securities. These transactions between the buyers and sellers are usually facilitated by intermediaries such as brokers and dealers who help with the identification of supply and demand interests in the market and assist in the process of the transaction.

This organised framework enables and facilitates investors to actively invest in financial securities as there is a continuous marketplace for securities trading, which mitigates concerns relating to liquidity and price fluctuations to a considerable extent. This instils confidence among investors as they feel a sense of security to park their funds in a regulated setup. The growth in participation in trading activities leads to better inclusivity in the market, which eventually leads to increased market stability. A good example of this is the spike in the participation of retail investors in the stock market during and after the COVID-19 outbreak, which has had a considerably positive impact on market stability.  

The secondary market allows investors to park their surplus funds to productive use and is a viable tool for portfolio diversification.

An important function of the secondary markets is price discovery. The continuity of trade that secondary markets provide enables the determination of the valuation of financial securities on the basis of demand and supply factors.

Furthermore, since secondary markets react quickly to any developments having a nationwide impact, they act as a viable tool for gauging the overall health and status of a country’s economic condition and its sectors.

Types of Secondary Market

Stock Exchanges – Stock exchanges are platforms regulated by regulatory authorities authorised by law, where buyers and sellers participate in trading and investment activities in financial assets and instruments.

As discussed earlier in this chapter, examples of stock exchanges in India include the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Similarly, some of the major stock exchanges in the world include the New York Stock Exchange in the United States, the Tokyo Stock Exchange in Japan, the Shanghai Stock Exchange in China, and the London Stock Exchange in the United Kingdom are a few global examples. In India, the stock exchanges are regulated by the Securities and Exchange Board of India (SEBI).

Trading on stock exchanges is facilitated by various intermediaries such as brokers and broking platforms, depository participants, banks and clearing corporations. Brokers and broking platforms act as a link between the investors and the stock exchanges and facilitate the meeting of buyers and sellers and the execution of trading orders by charging commissions. 

Depository participants act as a link between the investors and the depository and facilitate the opening and maintenance of demat accounts, storage of financial instruments and transfer of securities via the depositories. An investor who wishes to trade in financial instruments in the stock market cannot directly approach the stock exchanges or depositories. Rather, they must open a demat account to trade through a depository participant. The National Securities Depositories Limited and the Central Securities Depositories Limited are the two depositories in India.

Further, clearing corporations perform the functions of clearing and settlement of transactions. In India, the Clearing Corporation of India Limited is vested with this responsibility.

Over-the-counter market – OTCs are unregulated marketplaces where buyers and sellers directly carry out transactions on their own, without the involvement of any intermediaries and authorities. Due to the unregulated nature of OTC markets, market participants are prone to risks associated with counterparty default and liquidity issues. Further, due to the direct engagement of buyers and sellers, there is no price standardisation as buyers and sellers execute trades on customised terms and conditions to suit their requirements. The Foreign exchange market is an example of an OTC market.

Examples of Secondary Market Transactions

Secondary market transactions may take place in various forms. Some of these are as follows:

Stock trading – Acquisition of shares of any public company listed on a stock exchange from other investors, which refers to stock trading. For example, Tata Technologies recently launched its IPO and issued shares to investors through primary issuance. However, you could not participate in the IPO as you missed the deadline for submitting the IPO bid. You can still acquire shares of Tata Technologies by placing a purchase order with your broker or on your broking platform, which will identify a seller and assist with the execution of the trade.

Options Trading - Options trading involves dealing in derivative contracts wherein the buyer and seller enter into an agreement to buy or sell financial assets at a predetermined price on a predetermined date in the future. These non-binding contracts provide the option holder a right to exercise the option to buy or sell, which may be exercised at the discretion of the option holder. The option holder is required to pay a premium to be able to purchase the option contract.

Future Trading - Future trading involves dealing in derivative contracts wherein buyers and sellers enter into a standardised agreement for purchasing a specific quantity of financial assets at a specific price and at a specific date in the future. Futures are different from options in the sense that they are binding contracts, which means that parties are legally bound to honour the contract before the expiry date. Futures can only be traded on stock exchanges, which makes them averse to defaulting counterparty and credit risks. Futures trading is commonly seen in commodities trading, such as crude oil, gold and silver.

Mutual Fund Investments – A mutual fund is a pooled investment vehicle for investment in financial instruments such as stocks, bonds, money market and other securities. Mutual funds are managed by professional fund managers who invest money collected from multiple investors in a diversified portfolio of financial instruments. Mutual fund investments also involve the purchase of units of the fund from other investors in the secondary market.

Bond trading – Bonds are debt instruments or fixed-income instruments typically issued by corporations and governmental institutions for the purpose of raising capital from the market. In simple words, bonds are instruments that represent a loan granted by an investor to the borrower. Investors buy bond instruments from the secondary market to earn interest.

Pros and Cons of Secondary Market

Pros of Secondary Market

• Liquidity

Secondary markets provide liquidity to investors, enabling them to buy and sell securities easily. This liquidity is crucial for investors who may need to quickly convert their investments into cash.

• Price Discovery

The continuous trading of securities helps in the efficient discovery of prices, which are determined by supply and demand dynamics. This ensures that securities are fairly priced according to the market's current conditions.

• Information Efficiency

Secondary markets contribute to the efficient dissemination of information as prices adjust rapidly to new information. This helps investors make informed decisions based on the latest market data.

• Portfolio Diversification

Investors have access to a wide range of securities in the secondary market, allowing for easier portfolio diversification. This can help investors spread out their risk and potentially improve their investment returns.

• Regulation and Oversight

Secondary markets are often regulated by financial authorities, providing a level of safety and fairness to investors. Regulatory oversight helps reduce fraud and market manipulation, protecting investor interests.

Cons of Secondary Market

• Market Volatility

Secondary markets can be prone to volatility, with prices fluctuating widely in short periods. This can be due to various factors, including economic data releases, geopolitical events, or market sentiment, potentially leading to significant investment losses.

• Information Asymmetry

While markets strive for efficiency in information dissemination, there can still be cases of information asymmetry, where some market participants have access to information that others do not. This can lead to unfair advantages and losses for less-informed investors.

• Psychological Factors

Investor behaviour can often be driven by emotions such as fear and greed, leading to irrational decisions. This can exacerbate market movements, contributing to bubbles or crashes.

• Transaction Costs

Buying and selling securities in the secondary market can incur costs such as brokerage fees, which can eat into investment returns. While these costs have decreased with online trading platforms, they still exist.

• Counterparty Risk in OTC Markets

In over-the-counter (OTC) markets, where trades are not facilitated through a central exchange, there is a higher risk of counterparty default. This can lead to situations where one party fails to fulfil their financial obligations.

Bottom Line

In summary, the secondary market is a wide arena for investors seeking to achieve financial gains through dividends, capital gains, and understanding losses. It offers a multifold environment for trading existing securities, providing liquidity and opportunities for portfolio diversification. However, investors must navigate market volatility and remain informed to make prudent investment decisions.

As we move forward, the next chapter will delve into the intriguing world of short selling, a strategy that stands in contrast to traditional investment approaches. We will explore how short selling offers investors a unique opportunity to profit from declining stock prices, further expanding the toolkit available for navigating the complexities of the financial markets. So, stay tuned!