2. Primary and Secondary Markets Flashcards
Primary Market
The primary market, or the new issues market, is where securities are issued for the first time. The primary markets exist to enable issuers of securities, particularly companies, to raise capital, and to enable the surplus funds held by potential investors to be matched with investment opportunities the issuers offer. It is a crucial source of funding. The terminology often used when companies raise capital on the stock exchange is that they first access the primary market and float. The process that the companies go through when they float is often called the initial public offering (IPO). Companies can use a variety of ways to achieve flotation, such as offers for investors to subscribe for their shares (offers for subscription).
Stock Exchanges
Stock exchanges such as the LSE in the UK, and the NYSE in the US, are organised marketplaces for issuing securities and then trading those securities via their members. All stock exchanges provide both a primary and a secondary market.
Secondary Market
The secondary market is where existing securities are traded between investors, and the stock exchanges provide a variety of systems to assist in this, such as the LSE’s SETS that is used to trade the largest companies’ shares. These systems provide investors with liquidity, giving them the ability to sell their securities if they wish. Trading activity in the secondary market also results in the ongoing provision of buy and sell prices to investors via the exchange’s member firms.
United Kingdom Listing Authority (UKLA)
Each jurisdiction has its own rules and regulations for companies seeking a listing, and continuing obligations for those already listed. In the UK, there is the United Kingdom Listing Authority (UKLA) which is a division of the FCA. The formal description of the UKLA is that it is the competent authority for listing – making the decisions as to which companies’ shares and bonds (including gilts) can be admitted to be traded on the LSE. The rules are contained in a rule book called the Listing Rules.
The UKLA sets the rules relating to becoming listed on the LSE, including the implementation of any relevant EU directives. The LSE is responsible for the operation of the exchange, including the trading of the securities on the secondary market, although the UKLA can suspend the listing of particular securities and therefore remove their secondary market trading activity on the exchange.
Securities and Exchange Commission (SEC)
In a similar way in the US, the Securities and Exchange Commission (SEC) requires companies seeking a listing on the US exchanges (such as the NYSE and NASDAQ) to register certain details with the SEC first. Once listed, companies are then required to file regular reports with the SEC, particularly in relation to their trading performance and financial situation.
Users of Primary Markets
Issuers of new securities, such as corporations engaging in IPOs or follow-on offerings as well as the issuers of certain kinds of debt instruments, are the main suppliers of new securities in the primary markets.
The main purchasers of newly issued securities are large institutional investors such as pension funds, insurance companies and collective investment vehicles, such as unit trusts, which are buying the securities being offered on behalf of their clients, who are primarily members of the general public.
Users of Secondary Markets
In the secondary market, where existing securities are bought and sold throughout the daily trading sessions, there will be a variety of participants. In addition to the previously mentioned institutional investors engaged in the purchase of newly issued securities, these same institutions will, as a result of changes in their asset allocation decision making, be engaged in selling previously owned securities within their portfolio and, in turn, adding other securities which have been available in the secondary market previously. The constant shifting of priorities in portfolio allocation constitutes a large part of the transactional volume which arises each day, for example, in the activities of the LSE and the NYSE.
Also the secondary markets will be used by short-term speculators and traders who may hold securities for very short periods – perhaps even a few minutes or hours – when the motivation is to attempt to make profits from anticipating the direction of short-term price changes in the variety of securities which are available for trade in the secondary markets.
Increasingly the principal users of secondary markets are various funds and trading vehicles which engage in automated trading strategies – sometimes characterised as high frequency trading (HFT) when the objective is to exploit transitory price discrepancies which may exist in relation to quite complex algorithmic trading strategies.
Motivations for the Use of Primary Markets
The principal use and benefit of primary markets is to allow owners of capital to purchase new securities, which are made available from new issuers of securities. The issuers wish to raise capital for a variety of purposes, such as business expansion or acquisitions, and the buyers of the offerings wish to allocate their capital across what they perceive as attractive investment opportunities. In general terms, the holders of these newly issued securities are seeking longer-term investment objectives. However, some activity in the primary market – such as when there is a highly publicised IPO – may be for short- term speculative purposes. The manner in which some buyers of newly issued securities buy a new offering, and then, in the midst of some rather exaggerated market excitement about the new issue, sell the new issue shortly afterwards is known as flipping.
Motivations for the Use of Secondary Markets
The principal use and benefit of secondary markets is that they provide a liquid environment within which owners of securities may want to sell a current holding and when a willing buyer wants to purchase existing securities. The larger capitalisation issues are usually bought and sold in substantial amounts during each trading session and the spread, ie, the difference between the price that the securities are being offered – or the ask price – and the price that buyers are prepared to buy these securities – the bid price – is narrow. One characteristic of a liquid market is that spreads are narrow. Another feature which provides for more liquidity is the activity of speculators – including HFT activities – when the continuous buying and selling of securities with very short-term holding period horizons provides a depth to the secondary market, which would not be available if the secondary market only existed for institutions seeking longer-term investment reallocations.
Purpose of the Stock Exchange
Stock exchanges offer membership to investment banks and firms of stockbrokers. Becoming a member of an exchange enables these banks and stockbrokers to be involved in secondary market trades.
Stock exchanges provide trading platforms to enable listed securities to be bought and sold in the secondary market. As a consequence of the ongoing activities of the major participants in the secondary market – institutional investors, banks, and speculators – these exchanges provide liquidity to existing and potential investors, enabling existing investors to sell their securities and allowing potential investors to become actual investors by purchasing securities.
Furthermore, because these exchanges aggregate and integrate the trading activity on their systems as well as some alternative venues, the prices at which trades are executed is the market price at any given time. This is described as the price formation process, or sometimes markets are characterised as price discovery mechanisms.
Brokers
Brokers simply arrange deals for their clients, as well as potentially giving advice to their clients as to which securities they should buy, sell or retain. In return for arranging (and potentially advising), the brokers will earn a commission that is typically calculated as a set percentage of the value of the deal. Acting as a broker is often described as dealing as agent, and firms of stockbrokers tend to act as brokers on the stock exchanges.
Dealers
Dealers, in contrast to brokers, actually buy or sell securities. If a client wants to sell shares, a dealer may buy those shares; if another client wants to buy shares, a dealer may sell those shares. Acting as a dealer is often described as dealing as principal, because the dealer is taking a principal position by either buying, or selling the securities. It is the investment banks that tend to act as dealers on the stock exchanges.
Over-the-counter (OTC)
Over-the-counter (OTC) is the term given to trading which is conducted by networks of dealers and when the trading is not co-ordinated or subject to the formal procedures and standardised formats of an exchange. Many types of trading and investment activities are conducted on OTC platforms, including most in fixed-income markets and derivatives.
The transactions which are conducted in an OTC market result in bilateral contracts, in which two parties agree on how a particular trade or agreement is to be settled in the future. Such transactions are usually between an investment bank and its clients directly. Forwards and swaps are prime examples of such contracts and these deals are mostly done via a computer or telephone. For derivatives, the agreements are usually governed by an International Swaps and Derivatives Association (ISDA) agreement.
Dark Pool
Dark pool is the term that generally refers to an off-exchange trading venue where stocks are traded in large quantities without the prices being displayed until after the trade is done. The term ‘dark’ is used to describe the fact that pricing information cannot be seen. The opposite of dark pools are known as ‘lit pools’. Trading undertaken in this way is also commonly described as dark liquidity. The venues include both specialist crossing networks, such as Liquidnet and ITG Posit, as well as systems run by banks, such as Credit Suisse’s Crossfinder and Goldman Sachs’ Sigma X.
One investment manager has described the appeals of dark liquidity pools as follows:
A dark pool is a very simple way you can hopefully capture lots of liquidity and achieve a large proportion of your order being executed without displaying anything to the market.
In the US, the influx of crossing networks and alternative venues, and the rapid adoption of electronic trading technologies, has been driving the growth of dark pools for several years. Recent estimates state that there are currently more than 50 dark pools of liquidity in the US, and more than 30 in Europe. In the US, the dark pools are a form of what are referred to as alternative trading systems (ATSs) and, in Europe, they are a form of multilateral trading facility (MTF).
Off-Exchange Trading
In 1998 the SEC in the US authorised the introduction of electronic communication networks (ECNs). In essence, an ECN is a computerised trading platform which allows trading of various financial assets, primarily equities and currencies, to take place away from a specific venue such as a stock exchange. The primary motivation for the SEC to authorise the introduction of ECNs was to increase competition among trading firms by lowering transaction costs, giving clients full access to their order books and offering order matching outside of traditional exchange hours.
Since an ECN exists as a large number of networked computers/work stations, it effectively has no centre or physical location but rather is decentralised and virtual. ECNs are sometimes also referred to as alternative trading systems or venues.
Alternative trading systems (ATSs) have come to play a dominant role in public markets for accessing liquidity. The most popular among varieties of ATSs are ECNs and crossing networks.
An example of an ECN is Bloomberg’s TradeBook which, according to its website, describes its mission as follows:
(We) believe that traders equipped with advanced algorithms to manage complexity and supported by analytics to provide the right market insights can achieve superior executions. We partner with our clients to develop technology and services that give them better control of their transactions and keep them more informed of market opportunities.
Examples of crossing networks are run by Liquidnet, Aritas Securities (formerly Pipeline) and Posit. Liquidnet, which has a presence in Europe and in Asian markets, provides not only a crossing network, but is also a major provider, among others, of pools of dark liquidity as discussed in Section 2.2.2.
