What is Secondary Market? Meaning, Examples & Types Explained

What Is a Secondary Market?

A secondary market is a financial marketplace where securities which have been issued already are traded among investors. Such securities may consist of:

1. Fixed income instruments like bonds
2. Variable income instruments such as stocks and derivatives
3. Hybrid instruments such as convertible bonds

Unlike the primary market, where companies issue new securities to raise capital, the secondary market facilitates the buying and selling of previously issued securities between individual investors and institutional traders. These transactions occur on organised exchanges like the National Stock Exchange (NSE) or through over-the-counter (OTC) trading platforms.

Key players in secondary markets are brokers and banks who facilitate trades, and investors and traders who perform the buying and selling activity. There are also advisory service companies which often guide retail investors or aid the operations of big investors.

Meaning of Secondary Market

Other types of secondary markets exist in addition to stocks, which are one of the most commonly traded securities. Mutual funds and bonds are bought and sold on secondary markets by investment banks, corporations and individuals. Secondary market mortgages are also purchased by Fannie Mae and Freddie Mac.

Those transactions that take place on the secondary market are termed secondary because they are one step removed from the initial transaction that created the securities in question.

Different Instruments in the Secondary Market

The secondary market is a platform where various types of investment vehicles are traded, including fixed income securities, variable income securities, and hybrid securities.

1. Fixed Income Securities

Fixed income securities are types of investments that provide regular income through interest payments, with the principal amount being returned upon maturity. Common examples of these securities include bonds, debentures, and preferred stocks.

Debentures are a form of unsecured debt, meaning they are not backed by physical assets. The returns on debentures depend largely on the creditworthiness of the issuer.

Bonds represent a loan made by an investor to a borrower (typically corporate or governmental). They are a means for the issuer to raise funds by borrowing from investors, who in turn receive interest payments at predetermined intervals until the bond matures.

Preferred stocks give owners a priority claim on dividends over common stockholders and, in the event of liquidation, preferred stockholders are paid before common stockholders.

2. Variable Income Securities

These securities offer returns that vary based on several market factors, presenting a higher level of risk and potential reward for investors. Equity shares and derivatives are principal examples of variable income securities.

Equity shares represent ownership in a company, allowing shareholders to benefit from the company’s net profits and asset distribution in case of dissolution.

Derivatives are contracts between two parties that derive their value from the performance of an underlying entity. This financial instrument requires a payoff that depends on a specific outcome.

3. Hybrid Securities

Hybrid securities combine elements of both debt and equity, offering a versatile investment option. Convertible debentures are a prime example, acting as debt instruments that can be converted into equity shares of the issuing company after a certain period, under specific conditions.

Example of Secondary Market Transactions

All types of investors can benefit from secondary market transactions. Their costs are significantly reduced because of high-volume transactions. The following are a few examples of secondary market transactions involving securities.

Securities are traded on a secondary market between investors, not with the issuer. Investors who wish to purchase Larsen & Toubro stock will have to do so from another investor who owns such shares, not directly from L&T. Therefore, the company will not be involved in the transaction.

In a secondary market, individual and corporate investors, as well as investment banks, buy and sell bonds and mutual funds.

Types of Secondary Market

There are two types of secondary markets – stock exchanges and over-the-counter markets. Exchanges are centralised platforms where securities are traded without any contact between buyers and sellers. Examples of such platforms include the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).

Stock Exchanges

One will not find direct contact between the seller and the buyer of securities in this type of secondary market. Regulations are in place to ensure the safety of trading. In this case, the exchange is a guarantor, so there is almost no counterparty risk. Exchanges have a relatively high transaction cost because of exchange fees and commissions.

Over the Counter Markets

Investors trade among themselves on these decentralised markets. In such markets, there is fierce competition to get higher volumes, which leads to price differences between sellers. Due to the one-to-one nature of the transaction, the risk is higher than with exchanges. Examples of OTC markets include foreign exchange markets.

Read More – Dos And Don’ts While Investing In Secondary Market

How Does the Secondary Market Work?

Rather than trading directly with an issuer, investors trade in secondary markets. When you trade on a secondary market, the transaction occurs after the asset has already been issued on a primary market.

The mortgage market is a good example to use when discussing the secondary market, as it is another security that is commonly traded on the secondary market.

Financial institutions write mortgages for consumers, which is a form of mortgage security. A second transaction can be created when the bank sells the loan to Fannie Mae or Freddie Mac to finance the construction and sale of housing on the secondary market.

Main Functions of the Secondary Market

The secondary market performs the following important functions:

1. It provides a platform for investors to buy and sell securities once the securities have been issued.
2. It helps determine the fair price of securities based on demand and supply and facilitates in price discovery.
3. It provides liquidity to investors by allowing them to easily sell their securities.
4. It mobilises savings and investments by channelling funds from investors to companies.
5. It reduces the risk of investing by providing a regulated market that is transparent.
6. It provides a platform for companies to expand their value, based on market sentiment towards its performance.
7. Encourages corporate governance by increasing transparency among listed companies.
8. Promotes economic growth by providing a mechanism for allocating capital efficiently.

Advantages of the Secondary Market

The secondary market provides opportunities for capital appreciation for companies and investors on a fairly unbiased basis. The following are some of the advantages of the secondary market:

1. Facilitates trading: Once financial instruments are issued and purchased in the primary market, these instruments are then traded freely in the secondary market. The secondary market is a platform, usually powered by an exchange, where both retail and institutional buyers and sellers come together to trade in securities.
2. Liquidity: The secondary market ensures liquidity for investors. Investors and promoters can sell their securities on the secondary market to get cash. It also presents opportunities for interested buyers to buy securities for investment. 
3. Price discovery: The secondary market assists in the price discovery of securities. It functions as an indicator to assess the true market value of a company. Through constant buying and selling, the market eventually reaches the equilibrium that leads to price discovery.
4. Transparency and regulation: The secondary market is highly regulated and governed by established rules to protect investors’ interests.
5. Diversification: Investors can invest in a wide range of securities and diversify their portfolios in the secondary market. In the secondary market, investors can mobilise their savings quickly and efficiently.

Disadvantages of the Secondary Market

The following are some of the disadvantages of the secondary market:

1. Market volatility: Security prices in the secondary market are affected by several factors, including economic trends, corporate performance, investor sentiment, etc., which result in short-term price fluctuations.
2. Transaction costs: Trading in the secondary market involves transaction costs, which can reduce your overall return. Frequent trading can lead to higher expenses and cut into your final returns.  
3. Market manipulations: The secondary market is volatile and susceptible to manipulations, where individuals or groups may attempt to artificially inflate or deflate stock prices for personal gains. However, SEBI acts as a regulator to keep such manipulators in check.
4. Time-consuming: Dealing in the secondary market may be time-consuming and may require constant monitoring of the market. It can present emotional challenges and result in decisions made out of fear or greed.

Difference Between Primary Market and Secondary Market

The following are some of the major differences between primary and secondary markets:

Conclusion

Now that you know what is meant by the secondary market, you can start exploring it by downloading the Angel One app and opening a Demat account, for free!

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