A Guide to Secondary Markets for Investors
The secondary market is a common platform where securities are traded between investors. It is a figurative place where investors buy and sell securities they already own. Securities that anchor investors purchase from the primary market are further bought and sold between retail investors in the secondary market. The issuing company has no participation in these transactions. Usually, the stock exchanges of a country are referred to as the secondary markets; however, there can be other types of security markets as well.
This article walks you through all the minute details of the secondary market, its functions, types, examples, benefits and limitations. Read on!
How Does the Secondary Market Work?
Companies primarily issue stocks in the primary market to raise funds, and these initial stocks are purchased by anchor investors who, in turn, own a part of the companies as shareholders. Then, these stocks are sold in the secondary stock market to retail investors who purchase these stocks after the initial round of investments is over.
The securities then get bought and sold multiple times after via broker platforms without any involvement of the stock issuing company. The stocks get traded repeatedly in the secondary market based on market sentiments and stock performance.
What are the Functions of the Secondary Market?
Secondary markets are important because they are a financial instrument that influences the economic parameters of a nation. Some of its functions include:
1. Trading Securities
Trading various types of securities can be a profitable strategy to improve your financial health; however, these transactions can be risky if not done properly.
Secondary market depositories, such as the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE), monitor all listings and trades as per the guidelines of the Securities and Exchange Board of India (SEBI).
2. Economic Boost
Businesses and individuals invest capital in secondary markets in the hopes of turning a profit. Investing and reinvesting the returns results in a repetitive cycle. This boosts the economic growth of a nation and also ensures proper utilisation of the capital of a nation.
3. Pricing Parameter
Secondary capital markets set a margin for the right value of securities based on market demands. This helps to ensure the balanced trading of securities in the economy.
4. Credit Quality
The value of investment portfolios in the secondary market helps the Government and lenders understand the creditworthiness of the nation’s population.
5. Easy Access to Securities
Primary and secondary capital markets provide retail investors access to various types of securities that are associated with high liquidity.
Most retail investors fail to tap into the primary market for various reasons. Hence, the secondary market gives retail investors the chance to invest in liquid securities with minimum capital.
6. Easy Liquidity Gateway
Secondary markets have various investment instruments with different features. Most instruments in secondary capital markets offer high liquidity to investors. This allows investors an easy gateway during a financial crunch.
What are the Types of Secondary Markets?
In India, there are primarily two types of secondary markets. Additionally, with investment options expanding every day, there are several growing secondary markets.
1. Over the Counter (OTC) Market
Over the Counter or OTC market is a decentralised form of a secondary market. Investors trade among themselves in high volume without any immediate supervision of centralised authorities.
OTC markets have a higher chance of fraud and defaults than stock markets. This is because sellers and buyers trade directly without any intermediate participant, like a broker.
Stocks, bonds and other instruments can be traded in OTC markets. Foreign currency trading markets, known as FOREX markets, are prime examples of an OTC market.
2. Exchanges
This is the most popular type of secondary market among investors. Exchanges are platforms to trade equities, bonds and other securities via the Demat accounts of investors. The NSE and BSE are two stock exchanges in India that list and regulate all company shares in India.
These two depositories are regulated by the SEBI. Investors trade stocks and other securities through intermediate brokers registered under either NSE or BSE.
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What are the Types of Instruments in the Secondary Markets?
Secondary market provides a wide range of investment options to investors.
The different instruments have been categorised into three main types based on the income they offer to investors.
1. Variable Income Instruments
Market instruments that do not offer a fixed rate of return on investment are variable income instruments. These securities are high-risk assets with no fixed income rate.
These instruments expose investors to a high risk of default but offer high income as the return scope is not limited. As a result, variable instruments perform well in the market, which is why they are considered a popular investment option.
Despite its risk, investors who invest after doing thorough research benefit highly from such investments. An example of variable income instruments is equity stocks.
2. Fixed Income Instruments
Securities that offer a fixed rate of return or income with minimal chances of default are called fixed income instruments. These investments offer assured income and interest and are considered safer than variable investments. However, these instruments are not entirely free of risks but offer lower returns than stocks.
Examples of fixed-income instruments are government bonds, treasury bills, etc.
3. Hybrid Investments
When more than two types of different investment instruments are put together, it is considered to be a hybrid investment. It is not necessary for the combined instruments to be both variable and fixed. An example of hybrid investments is convertible debentures.
Example of a Secondary Market Transaction
Secondary market transactions take place between two or more investors, not with the issuing participants. The following transaction is a simple secondary market example.
Let’s say Mr. A is an investor who wants to buy 20 stocks of ABC India Limited from the stock exchange. Mr. B has holdings in ABC India Limited and wants to sell 10 stocks. Similarly, Mr. C and Mr. D have holdings in the same company and want to sell 5 stocks each.
When Mr. A initiates a buy request, and the others initiate a sell request, the stockbroker will match these requests and sell the stocks of the sellers against the demand of the buyer. However, ABC India Limited won’t be involved in these transactions. These stocks will only be bought and sold among the involved participants.
What are the Advantages of Secondary Markets?
There are several advantages of investing in the secondary market, which benefits investors, companies and the economic structure of a nation. Some of them have been discussed below:
1. Source of Income
Investors can utilise secondary market investments for capital gains.
2. Safety
Secondary markets are regulated and offer security to investors over their capital and income.
3. Economic Growth
Investing in secondary markets offers investors the opportunity to contribute to the growth of their nation’s economy.
4. Market Value
Securities trading in secondary stock markets provides the fair price of different stocks listed on two exchanges.
5. Access to Cash
Investors get access to cash as liquidity is high for secondary market investments.
6. Creditworthiness
Investments in securities are good indicators of a healthy credit score for individuals.
What are the Disadvantages of Secondary Markets?
These are the disadvantages associated with secondary market investments:
1. High Risk
Investing in stocks and other secondary market instruments is subject to high risk due to the involvement of multiple market participants and investors.
2. Effects of Inflation
Inflation negatively affects the performance of secondary market securities and increases the risk of loss for investors.
3. Lack of Control
Individual investors do not have direct control over their investments as several factors influence market trends.
What are the Differences Between Primary and Secondary Markets?
These primary differences between primary and secondary markets are:
| Primary Markets | Secondary Markets |
| Securities are created in this market and issued to investors. | Securities are traded in this market after the initial investment round. |
| Issuing entities are directly selling to the investors. | Issuing entities are not a part of these trades. |
| The objective of these trades is to raise funds. | The objective of these trades is to earn profit and invest capital. |
| Investment banks are the intermediate participants. | Brokers are the intermediate participants. |
| Equity prices are fixed. | Stock prices fluctuate constantly. |
| Minimum investment is usually a large amount. | Minimum investment is comparatively less. |
Final Word
Secondary markets offer various investment options to retail investors with the added benefit of portfolio diversity. Primary capital markets and secondary capital markets both offer securities to investors; however, secondary markets provide more opportunities for retail investors to grow their capital and earn profits.
FAQs
Ans: Secondary markets are accessible for retail investors and provide an opportunity to invest in major stocks without bulk capital. It is also a good exit platform for primary market investors.
Ans: It is not possible to compare the two markets in general as both markets have benefits for different investors. Secondary market might be a better option for retail investors, while the primary market can be the go-to market for large investors.
Ans: There are two primary types of secondary markets – Stock exchanges and Over-the-counter (OTC) markets. Some other secondary market types are the Auctions market and Dealers market.
Ans: There are two popular secondary markets in India, namely the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). These exchanges are regulated by the Securities and Exchange Board of India (SEBI).
Ans: Securities and Exchanges Board of India (SEBI) is the government body that regulates and monitors all listings and activities of securities markets. Depositories registered under SEBI act as intermediate participants between secondary market transactions to ensure authentic and safe transactions.
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