Learning Outcomes
By the end of this section, you will be able to:
- Identify primary and secondary markets.
- Identify key market players.
Primary and Secondary Markets
Simply put, the primary market is the market for “new” securities, and the secondary market is the market for “used” securities. Think of the primary market as equivalent to the sale of new cars and the secondary market as equivalent to the sale of used cars. In practice, many market locales trade both new and used securities. For example, the stock markets trade equity securities daily, and most of the trading takes place among individual and institutional investors who own shares in publicly traded companies. Trading a share of Amazon, Facebook, or Nike stock has little impact and no direct cash flow to the underlying firm. However, the information provided by such transactions is valuable, as it is a costly and public real-time statement by investors of their perceptions of firm’s value and a reflection of satisfaction and expectations.
Some, though many fewer, transactions in the equity market are for the purchase and sale of new securities. Firms issue new shares of stock called seasoned equity offerings (SEOs) or initial public offerings (IPOs) into the market. These are issues of new shares of stock, previously untraded, and their issuance sends cash flows directly to the underlying firms. SEOs are new shares issued by established firms, and IPOs are new shares issued by firms going public for the very first time. Once the initial transaction takes place, purchasers of these new securities may trade them. However, the second and subsequent trades are secondary, not primary, market transactions.
Extensive primary market transactions take place weekly, when the Treasury Department auctions billions of dollars of new Treasury securities. These new securities repay maturing Treasury securities and provide for the ongoing liquidity and long-term borrowing needs of the federal government. Again, subsequent trading of this government debt occurs as secondary market transactions.
Key Market Players
Key market players in finance include dealers, brokers, financial intermediaries, and you and me. Each of these players facilitates the exchange of products, information, and capital in different ways. The presence of these players makes financial transactions, easier, faster, and safer—essentially more efficient. You and your friends might engage in direct financial transactions, such as buying a coffee or borrowing money for a movie. These are typically small transactions. However, for transactions that are larger or more complicated, you need advanced financial entities with capital, expertise, and networks. The two segments of the secondary markets are broker markets and dealer markets, as Figure 1.7 shows. The primary difference between broker and dealer markets is the way each executes securities trades.
Dealers
Financial dealers own the securities that they buy or sell. When a dealer engages in a financial transaction, they are trading from their own portfolio. Dealers do not participate in the market in the same manner as an individual or institutional investor, who is simply trying to make their investments worth as much as possible. Instead, dealers attempt to “make markets,” meaning they are willing and able to buy and sell at the current bid and ask prices for a security. Rather than relying on the performance of the underlying securities to generate wealth, dealers make money from the volume of trading and the spread between their bid price (what they are willing to pay for a security) and their ask price (the price at which they are willing to sell a security). By standing ready to always buy or sell, dealers increase the liquidity and efficiency of the market. Dealers in the United States fall under the regulatory jurisdiction of the Securities and Exchange Commission (SEC). Such regulatory oversight ensures that dealers execute orders promptly, charge reasonable prices, and disclose any potential conflicts of interest with investors.
Brokers
Brokers act as facilitators in a market, and they bring together buyers and sellers for a transaction. Brokers differ from dealers who buy and sell from their own portfolio of holdings. These firms and individuals traditionally receive a commission on sales.
In the world of stockbrokers, you may work with a discount broker or a full-service broker, and the fees and expenses are significantly different. A discount broker executes trades for clients. Brokers are required for clients because security exchanges require membership in the exchange to accept orders. Discount brokers or platforms such as Robinhood or E-Trade charge no or very low commissions on many of their trade executions, but they may receive fees from the exchanges. They also do not offer investment advice.
Full-service brokers offer more services and charge higher fees and commissions than discount brokers. Full-service brokers may offer investment advice, retirement planning, and portfolio management, as well as execute transactions. Morgan Stanley and Bank of America Merrill Lynch are examples of full-service brokers that serve both institutional and individual investors.
Financial Intermediaries
A financial intermediary, such as a commercial bank or a mutual fund investment company, serves as an intermediary to enable easier and more efficient exchanges among transacting parties. For instance, a commercial bank accepts deposits from savers and investors and creates loans for borrowers. An investment company pools funds from investors to inexpensively purchase and manage portfolios of stocks and bonds. These transactions differ from those of a dealer or broker. Brokers facilitate trades, and dealers stand ready to buy or sell from their own portfolios. Financial intermediaries, however, accept money from investors and may create a completely different security all together. For example, if the borrower defaults on a mortgage loan created by the commercial bank where you have your certificate of deposit, your investment is still safely earning interest, and you are not directly affected.
Financial institutions usually facilitate financial intermediation. However, occasionally lenders and borrowers are able to initiate transactions without the help of a financial intermediary. When this occurs on a large scale, the process, known as disintermediation, can cause much turmoil in the financial markets. In the 1970s, inflation rose above 10% on an annual basis, and yet commercial banks were limited to offering maximum rates of 5% on their savings deposits.7 Savers bypassed banks and savings and loan associations to invest directly into Treasury securities and other short-term marketable securities. This lack of deposit funds and the subsequent behavior of the industry essentially eliminated the savings and loan industry and led to significant deregulation of commercial and investment banking in the United States.
The advantages of a robust network of financial intermediaries are many. They add efficiency to the financial system through lower transaction costs. They gather and disperse information to minimize financial abuse and fraud. They provide economies of scale and specialized knowledge. Finally, financial intermediaries are critical for the functioning of a capitalist economy.
Footnotes
- 7United States President and Council of Economic Advisers. “The 1970s: Inflation, High Interest Rates, and New Competition.” Economic Report of the President. 1991. https://fraser.stlouisfed.org/files/docs/publications/ERP/pages/6688_1990-1994.pdf