What is a Secondary Market?

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Definition:

The secondary market is where traders buy and sell financial instruments among one another, as opposed to buying them directly from an issuing company.

🤔 Understanding the secondary market

The secondary market is any place that people trade securities (financial items that have monetary value, such as stocks and bonds) after initial public offering. It contrasts with the primary market, in which securities are sold for the first time. For example, the New York Stock Exchange (NYSE) is generally a secondary market for shares of equity in companies. The initial public offering (IPO) is the first sale of shares. From there, traders exchange those shares with one another in the secondary market. While the IPO is a way for the company to raise capital, trades on the secondary market update the current market value of that stock.

Example

When the United States federal government wants to raise money, it periodically issues debt instruments. For example, it might offer a 30-year U.S. Treasury Bond that pays $100 at maturity, plus a 1.5% interest rate. When the Department of the Treasury auctions these bonds off, the proceeds go toward paying for government services. But the buyer doesn’t have to hold the bond for 30 years. At any point along the way, they can resell that bond on the secondary market.

Takeaway

The secondary market is like re-gifting a present at Christmas…

When the office decides to do a secret Santa, everyone brings a small present. One option is to go to the store and buy something nice. But another choice is to give something away that you already own. You could just re-wrap the present you got last year. Similarly, bringing something to the secondary market is reselling something you already own. Just as buying on the market is like buying a gift from its current owner instead of from a store.

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What is a secondary market?

The secondary market is where securities get traded after the initial sale. For example, when a company first issues a corporate bond, it happens in the primary capital market. The money goes from the investor to the company. Later, the investor may want to sell that bond. Perhaps they need cash. Or maybe they want to mix up their portfolio (collection of investments). They can do that by finding another investor that’s willing to buy the bond from them. The current owner and the potential buyer can decide what they think a fair price is.

Since this bond was sold at least once before, it’s now considered to be on the secondary market. Sometimes the secondary market is a formal marketplace, like a stock market. But any security that isn’t a newly issued instrument is on the secondary market.

The same idea applies to equity in a company. When a company first issues shares of common stock, that happens in the primary market. The company usually hires an investment bank and launches an initial public offering (IPO). Whatever money the IPO raises goes to the company to invest in growing the business. After the IPO, the investors that bought the new stock can sell it on the stock market. Those transactions between traders are called secondary market transactions.

What is the role of secondary markets?

While the role of the primary market is to raise capital for companies, the secondary market provides liquidity (the ability to turn financial assets into cash quickly) for investors. Without a secondary market, investors would need to hold those assets until maturity. In the case of equity in a company, an investment could be a lifelong endeavor.

Without secondary markets, the only way to turn an asset into cash would be to sell the stock back to the company. Of course, the company issues shares to raise the money it needs. Repurchasing the stock would mean giving up that capital. There are times in which that might make sense, but it might not coincide with when the investor needs cash on hand.

Perhaps the investor is buying a house and needs to make a down payment. If all their money is tied up in stock, they don’t have the cash to close the deal. The secondary market allows them to get out of the investment. By selling their interest to someone else, the investor can access the money they need while the company keeps the capital it raised.

What are the types of secondary markets?

Anything that gets resold is being traded on the secondary market — So, there are many types of secondary markets. In finance, the secondary market refers specifically to reselling financial instruments. So, many of the places traders go to buy and sell assets are part of the secondary market. Because each asset gets traded many times, the secondary market makes up the majority of all activity in the financial markets.

Stock market

Except for an initial public offering (IPO), all of the trades on a stock exchange, like the NASDAQ or London Stock Exchange, happen between traders. That means that the stock market is almost exclusively part of the secondary market.

Over-the-counter market

When traders buy and sell stocks, contracts, and other financial instruments outside the stock market, they happen over-the-counter (OTC). These OTC transactions are less regulated than the stock exchanges, but they offer a greater variety of investment opportunities. People sometimes trade unlisted stocks OTC, making it a sort of secondary stock market. Exchanges that allow buyers and sellers to post their interest are part of the OTC market. Almost all of these trades are part of the secondary market.

Bond market

Corporations and governments often issue bonds to raise capital. The initial issuance of such bonds usually happens through an auction. Each bond has a maturity date, at which time the current owner gets a payment. But, the person that first purchases a bond doesn’t have to hold it until it matures. When investors buy and sell bonds from each other, rather than from an issuing entity, they are participating in the secondary market.

Loan market

Investors sometimes offer loans to people or companies that need capital. A loan is a debt instrument like a bond. But it typically has a different repayment schedule than a bond does. For example, a five-year car loan requires principal and interest payments each month. Over time, the balance goes down until it reaches zero at the end of the loan term — A process called amortization. A bond might pay interest every six months, then has a balloon payment when it matures.

Like a bond, these loans are financial instruments that can change hands. A lender can sell a loan to another bank or collateralized debt obligation (an investment structure that repackages debts into other financial instruments). The buying and selling of loans happen in the secondary market.

What is the secondary mortgage market?

When a bank loans someone money to buy a house, it’s called a mortgage. That’s a primary market transaction between a financial institution and a borrower. The mortgage is a financial asset for the bank, but it doesn’t necessarily need to keep the loan for 30-years. Instead, it can sell that asset on the secondary mortgage market. That frees up the bank's money to make more loans.

Other financial institutions might want to buy that mortgage. Or an investment company might want to buy a whole bunch of mortgages as part of its strategy. The standard way to do that is to repackage the loans, then use the mortgage payments as the cash flow to pay off the investors. This structure is called a collateralized loan obligation (CLO), and the instruments it sells are called mortgage-backed securities.

What are the functions and characteristics of secondary markets?

Secondary markets do a lot of things. For one, they function as a gauge of the health of the economy. While the stock market isn't the economy, it does provide information about how the economy is doing. Because stock prices reflect investor expectations, they’re often a leading indicator of the general economy.

If the secondary market for stocks is growing, it’s a signal that investors think businesses will grow. If the stock market tanks, there’s a decent chance that employment and wages are on the way down too. In this way, the secondary market can warn of recession before it happens.

Another characteristic of the secondary market is that it provides a current market price for financial assets. Without a secondary market, it’d be impossible to know what the fair market value for a stock or bond would be. Because trades are happening every second of every trading day, the secondary market gives a clear answer to what something is worth.

What is the difference between primary and secondary markets?

The primary market is where private companies and governments go to raise capital. They issue shares of stock through an initial public offering (IPO) or issue debt through bonds or loans. These financial instruments are created for the first time in the primary market. The investor buys them directly from the issuing entity.

The secondary market is like a second-hand store. It’s where you go to buy and sell things that aren’t new. When an investor buys or sells stocks, bonds, or other securities from another investor — rather than from the issuing entity — it happens on the secondary market.

The main difference between the primary and secondary markets is that the primary market generates capital for companies, while the secondary market creates liquidity (cash flow) for investors.

Ready to start investing?
Sign up for Robinhood and get stock on us.Certain limitations apply

New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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© 2022 Robinhood. All rights reserved.