Introduction
Financial markets play a central role in the global economy by serving as the hub for the exchange of capital and investment products. A Capital Market encompasses all institutions, organizations, and instruments that facilitate the provision of medium and long-term funds. Various instruments in a capital market include debentures, shares, bonds, public deposits, mutual funds, and more.
These capital markets are broadly classified into primary and secondary markets, each fulfilling distinct functions within the financial ecosystem. This blog will explore the characteristics, activities, and participants of both primary and secondary markets, providing insights into their vital roles in the world of finance.
Difference between Primary and Secondary Markets
When you purchase a new T-shirt from Puma, you’re buying it in the primary market, where the T-shirt is being sold to the public for the first time. On the other hand, if you find a similar T-shirt at a thrift shop, you’re in the secondary market.
The financial world also has primary and secondary markets. In the primary market, new securities like bonds or stocks are initially sold by companies or governments to financial intermediaries, like broker-dealers, or directly to investors. Once these securities are first sold, any subsequent transactions involving them occur in the secondary market, which can be an exchange.
Primary Market
The primary market serves as the birthplace of new securities, where issuers introduce their financial instruments to the public for the first time. This market plays a pivotal role in facilitating the initial exchange between the issuer and investors, paving the way for capital formation. The sale occurs between an investor and the issuer, usually with an investment bank working as an intermediary, known as an underwriter.
The issues are highly regulated by bodies such as the Financial Conduct Authority (FCA) in the UK, and the Securities and Exchange Commission (SEC) in the US, and Securities and Exchange Board of India (SEBI) in India. These regulatory bodies play a crucial role in regulating and supervising the securities market to ensure transparency, fairness, and investor protection.
The specific procedure may differ based on the nature of the security and the preferences of the issuer, but typically adheres to one of the ensuing models:
Initial Public Offerings (IPOs)
One of the primary methods through which companies raise capital is by going public. During an IPO, a company issues shares to the public for the first time, allowing investors to become partial owners of the business. This process injects fresh capital into the company, enabling it to finance expansions, research, and other strategic initiatives. When privately owned firms decide to become publicly traded, they often opt for an initial public offering (IPO) to introduce their shares to the public market. To do this, the company submits a prospectus to their country’s securities regulator (such as the SEC in the U.S., SEBI in India), which provides investors with additional details.
Examples of IPOs
Facebook, now known as Meta Platforms, Inc., conducted its Initial Public Offering (IPO) on May 18, 2012, on the NASDAQ stock exchange, offering 421 million shares at a price of $38 per share and raising approximately $16 billion, marking one of the largest technology IPOs in history at that time.
Uber Technologies Inc., a ride-hailing and food delivery platform, went public on the New York Stock Exchange on May 10, 2019, raising about $8.1 billion, though experiencing some volatility in its early days of trading.
Airbnb, Inc., an online marketplace for lodging and travel experiences, had its IPO on December 10, 2020, on the NASDAQ, raising around $3.5 billion, and witnessing a significant increase in valuation on the first day of trading.
Debt Issuance
In addition to equities, the primary market also facilitates the issuance of debt securities. Governments, municipalities, and corporations issue bonds to raise funds for various projects. Investors purchase these bonds, essentially lending money to the issuer in exchange for periodic interest payments and the return of the principal amount at maturity.
Examples of Debt Issuance:
The U.S. government regularly issues Treasury bonds to fund various initiatives, such as infrastructure projects, social programs, and to manage its budget deficits. Treasury bonds come in different maturities, such as 10-year, 20-year, and 30-year bonds. Investors purchase these bonds, and the government pays periodic interest until the bond matures.
Indian Government issues bonds like “Government of India Savings Bonds” to finance various projects and manage fiscal policies. These bonds are non-tradable and typically have a fixed tenure with periodic interest payments. Investors, including both domestic and non-resident Indians, can invest in these bonds to support government initiatives.
Many municipalities issue bonds to finance infrastructure projects like building schools, highways, or water treatment facilities. For instance, a city might issue bonds to build a new public transportation system, and investors in these bonds receive interest payments.
Companies like Apple Inc. and Microsoft issue corporate bonds to raise capital for expansion, research and development, financing acquisitions or investing in new technologies, or other business activities. Investors who buy these corporate bonds are essentially lending money to the company. These companies pays periodic interest to bondholders until the bonds reach maturity.
Auction
The auction market has transformed from the traditional open outcry system, where participants physically gather in one location to announce their bids and offers, to online auctions, enable individuals to engage in buying and selling activities from the comfort of their own homes or offices. This evolution has been fueled by advancements in information technology and internet connectivity, fostering a desire for increased efficiency. Online auctions allow buyers and sellers to participate from anywhere, eliminating geographical barriers and expanding the market globally.
Treasury bonds are typically sold through public auctions. A select group of financial institutions, referred to as primary dealers, submit competitive bids for the bonds they intend to purchase, specifying the desired rate they are willing to accept. The majority of participants are noncompetitive bidders, indicating their willingness to accept the rate determined through the competitive bidding process.
Example of Auction
Let’s consider a scenario where the Treasury aims to raise $9 million through one-year T-bills with a 5% discount rate. The minimum amount one can purchase a bill for is $100. Competitive bids are submitted, ranging from $1 million at 4.79% to $5 million at 5.5%, Bids with the lowest rates are prioritized, as the government prefers to pay lower yields to investors. In this example, bids totaling $7.5 million at or below 5.07% are accepted. All bids below this rate are accepted, while those above are rejected. Consequently, the auction concludes at a 5.07% discount rate, and successful bidders receive this specified rate.
Individual investors have the opportunity to participate in Treasury auctions either through a securities dealer, typically a brokerage firm, or via the Treasury Direct program, which offers a direct avenue for participation and eliminates the need for brokerage commissions.
Direct listing
Unlike an IPO, a direct listing (also known as a direct public offering or DPO) enables a company to have its current shares traded on an exchange without creating new shares. This path is often chosen by companies that have already received multiple rounds of private funding from venture capital and private equity investors. In some cases, founders, venture capital firms, or private equity investors may exchange ownership interests among themselves without going public, and these exchanges are referred to as private equity secondary.
Examples of Direct Listing
Technology startups have increasingly favored direct listings over traditional IPOs, with notable examples including Spotify (SPOT), Slack (WORK, acquired by Salesforce in 2020), Palantir (PLTR), Asana (ASAN), and Coinbase (COIN).
Direct listings and IPOs have distinct methods but share common goals: achieving a public listing, transferring equity ownership to a wider market, and offering liquidity events for existing owners, like venture capital firms.
Private Placement
Private placement is when a company sells stocks or bonds to a small group of special investors without going through the complex process of becoming publicly traded. These special investors are usually big organizations like pension funds, endowment funds, or high-net-worth investors (HNI).
Examples of Private Placement
SpaceX, the aerospace manufacturer and space transportation company founded by Elon Musk, has engaged in several private placements to fund its ambitious projects. For instance, in 2015, Google and Fidelity jointly invested $1 billion in SpaceX in a private placement, valuing the company at around $10 billion.
Tesla, the electric car manufacturer, utilized private placements to raise capital before its IPO in 2010. In 2009, Daimler AG, the German automaker, invested $50 million in Tesla through a private placement. This strategic investment helped Tesla as it faced financial challenges during that period.
Initial Coin Offerings (ICO)
In the world of cryptocurrencies, an initial coin offering (ICO) refers to an unregulated fundraising method where investors exchange cash or other crypto assets for crypto coins or tokens. These tokens signify ownership and, in some cases, may grant voting rights, similar to traditional shares of stock. ICOs empower blockchain startups by democratizing fundraising, offering global reach, providing liquidity through tradeable tokens, adding intrinsic value with token utility, and driving innovation in areas like DeFi, NFTs, and supply chain management.
Examples of ICOs
Ethereum conducted one of the most well-known ICOs in 2014, raising funds over $18 million by selling Ether (ETH) tokens to investors. These funds were used to help build the Ethereum blockchain. Now, Ethereum is one of the main places for decentralized apps and smart contracts.
Ripple, the company behind the XRP cryptocurrency, initially funded its development through various rounds of investment, including an early ICO. Ripple aimed to provide a faster and more cost-effective cross-border payment system..
Secondary Market
Once securities have been issued in the primary market, they find a new home in the secondary market. This market is characterized by the trading of existing securities among investors, without the involvement of the issuing entity. The secondary market provides liquidity and allows investors to buy and sell securities after the initial issuance.
Key activities within the secondary market include:
Stock Trading
Investors engage in the buying and selling of shares of publicly traded companies. Stock exchanges serve as the platforms where these transactions take place, fostering a dynamic marketplace for equity securities.
Examples of Stock Trading
New York Stock Exchange (NYSE), London Stock Exchange (LSE), NASDAQ, Bombay Stock Exchange (BSE), National Stock Exchange (NSE)
For instance, an investor purchases 100 shares of Apple Inc. (AAPL) on the NYSE at $150 per share. The stock price increases to $175, and the investor sells to capitalize on the appreciation.
For instance, shares of companies like Reliance Industries Limited (RIL), Infosys Limited, and State Bank of India (SBI) are commonly traded on the NSE.
Derivatives Trading
The secondary market for derivatives, such as futures and options, allows investors to engage in complex financial instruments. Derivatives derive their value from an underlying asset, and their trading can be speculative or used for risk management purposes.
Examples of Derivative Trading
An investor might enter into a futures contract to buy a specified quantity of a commodity (e.g., crude oil, gold, wheat) at a predetermined price on a future date. This can be used for hedging against price fluctuations or for speculative purposes.
A stock options contract gives the holder the right (but not the obligation) to buy or sell a specific quantity of shares at a predetermined price before or at the expiration date. Investors may use options to speculate on price movements, hedge against potential losses, or generate income.
The Chicago Mercantile Exchange (CME) is a well-known exchange where futures and options contracts on various commodities, financial instruments, and indices are traded. Investors can enter into agreements to buy or sell assets at a future date at a predetermined price.
Over-the-Counter (OTC) Market
The OTC market includes decentralized platforms where securities, such as bonds and certain stocks, are traded directly between buyers and sellers. The NASDAQ OTC Market is an example where many technology stocks are traded.
Instruments traded on secondary markets comprises of equities, such as shares and exchange-traded funds (ETFs), as well as fixed-income instruments like bonds. While commodities and currencies also undergo trading in public marketplaces, they are not categorized as secondary markets since there is no primary issuance involved.
To learn more about tradable asset classes in the secondary market, please click here.
Bonds Trading in the Financial Markets: Primary vs. Secondary
In the primary market, a new video game is released with a set price and features. Consumers purchase it from the store, and the funds generated go to the game developer.
Once the game has been played and the consumer wishes to sell it to a friend, this transaction occurs in the secondary market. The game developer is not involved; instead, the interaction is between the buyer and seller. If the sale is conducted through a game store, they may assist with the transaction. The resale price is influenced by factors such as the game’s popularity, demand, and the condition of the game. Consequently, the price of the game in the secondary market may differ from the original store price due to various considerations.
Similarly, new bonds are initially sold to investors in the primary market. During this phase, initial terms such as price and interest rates are established, and the issuer receives the proceeds from the sale.
When bonds are traded between investors, it occurs in the secondary market, and the issuer is not directly involved in these transactions. Brokerage firms often facilitate these transactions by connecting buyers and sellers or participating in the trades themselves. The price in the secondary market is influenced by factors like interest rates, supply and demand dynamics, and the credit quality of the bonds. This secondary market price may deviate from the original price set in the primary market.
Although bond prices and yields fluctuate based on supply and demand, the contracts typically have fixed principals (initial investments) and coupon rates (interest paid at fixed intervals throughout the contract’s maturity). As a result, bonds are generally less volatile than stocks unless interest rates change.
For instance, if an individual pays $1,000 for a bond, they receive interest payments every six months based on the coupon rate. If the rate is 6%, they would receive $30 every six months, totaling $60 per year. Upon maturity in twenty years, the investor gets back the original investment of $1,000, known as the principal.
If interest rates rise, the price of bonds on the secondary market typically falls. This is because newer bond issues come with greater incentives for investing, decreasing the demand for older bonds. This phenomenon is known as interest rate risk. The longer the duration of a bond, the more sensitive its price is to changes in interest rates, as there is a greater chance it will be exposed to this risk. Conversely, if interest rates fall, the price of bonds on the secondary market will usually rise, as higher interest rates become more attractive.
Key Participants in Capital Markets
Participants in the primary market include the issuers (companies or governments) seeking capital and investors looking to acquire newly issued securities. The interaction between these entities forms the foundation of the primary market, shaping the initial stages of a security’s life cycle.
Participants in the secondary market include retail investors, brokers, Institutions such as insurance companies, banks and mutual funds, trading securities among themselves. The secondary market’s liquidity and price discovery mechanisms contribute to the overall efficiency of the financial markets.
To explore further information about key participants in the capital market, please click here.
Significance of Secondary Markets
In finance, the secondary markets are usually busier than the primary markets. This is because securities, like stocks, are interchangeable, meaning that one is just as good as another. For example, two shares of IBM stock are considered the same, regardless of who owned them before or when they were first sold to the public.
In financial terms, secondary markets enable securities to be bought and sold long after the initial sale by the issuer. This active market provides liquidity and reassures issuers that there will be people willing to buy when they decide to sell more securities in the primary market.
Evolution of Securities Trading: From Traditional Brokerages to Modern Online Platforms and Mobile Apps
When engaging in the buying or selling of stocks through an online platform, the actual transaction occurs on a specialized platform known as an execution venue, such as a stock exchange or over-the-counter market. However, regular people like us don’t directly deal with these places. Instead, we use a middleman called a broker to make these trades for us. In the era before electronic markets, this process involved calling or physically visiting a broker’s office, formulating a trading plan, and enduring hours or even days of waiting for the broker to execute the trade on the exchange.
In today’s landscape, the process has evolved, and one can conveniently buy and sell securities, often commission-free, through an online brokerage platform or a mobile app. Opening a trading account enables individuals to take positions in stocks, currencies, or cryptocurrencies through Contracts for Difference (CFDs). Alternatively, you can practice with a demo account using virtual money to boost your confidence before investing real money.
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Educational Empowerment: Enhancing Financial Literacy with Tradeshala
Navigating the financial markets requires a nuanced understanding of both the primary and secondary markets. The primary market facilitates the issuance of new securities, enabling companies and governments to raise capital, while the secondary market provides a platform for the ongoing trading of existing securities among investors. Together, these markets form the backbone of the global financial system, influencing economies and shaping the future of investments. Understanding the distinct functions and activities of these markets is essential for investors, financial professionals, and anyone seeking a deeper comprehension of the intricate world of finance. At Tradeshala, we continue our commitment to demystifying the world of finance.
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Stay tuned for more insights, analyses, and updates as we journey through the ever-evolving landscape of financial markets.
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Written By-
Mini Agarwal
Specialist Tutor & Research Analyst