What are Primary and Secondary Markets

To understand a secondary financial market (frequently called an “aftermarket”), it is helpful to know what the primary financial market is. A primary market is one in which stocks or other financial instruments are sold for the first time. The secondary financial market, by contrast, is where previously issued investment tools are sold.

Primary Financial Market

In the primary financial market, investors purchase directly from the issuers of stock. For example, a stock is offered for the first time in an initial public offering (IPO) by the bank underwriting the corporation‘s stock. In the case of buying treasuries, investors purchase these from the US government. Once those stocks or bonds have been owned, they can be re-sold to other investors, but only on the secondary market.

Secondary Financial Market

The most commonly thought-of secondary financial market is the stock exchange. Here buyers and sellers trade stock through the American Stock Exchange, NASDAQ, and New York Stock Exchange. Most bonds and other investment products are sold “over the counter” through brokerage houses. Loans sold by mortgage banks to investing entities such as Fannie Mae and Freddie Mac are also part of the secondary financial market.

In the secondary market, the cash from the purchase of investments goes directly to the investor, rather than to the issuing corporations (as with stock). In the secondary market, prices are based on the principles of “supply and demand,” whereas in the primary market, stock and bond costs are predetermined.

A well-functioning secondary market is important because it keeps the assets in the marketplace liquid. By providing a place (such as the stock exchange) where many investors and speculators can come to buy and sell financial instruments, the more the marketplace is kept “liquid.” Liquidity is important because it keeps prices from fluctuating wildly and ensures a stable economic environment. When a market is liquid, there are always willing buyers and sellers.

One example in which stability took a dive recently was with the sub-prime mortgage crisis. Although the assets (mortgages) were backed by real assets (houses), the values could not be assured, and the mortgages became illiquid values, and the economy was shaken as a result.

Auction and Dealer Markets

The secondary financial market can be further subdivided into the auction market and the dealer market. Often the dealer market is called the “over the counter” (OTC) market. The most obvious example of the auction market is the stock exchange, where all the private investors and institutions come to buy and sell (or “bid” and “ask”). In the dealer market, electronic trading tools are utilized, and dealers “make a market” to buy and sell for their clients.

Markets are essential for financial instruments to be traded easily, and the secondary market, which is often taken for granted, is critical to liquidity. Just imagine trading without it. Individual stock owners (on their own) who wanted to sell would have to find other individuals who wanted to buy, approaching each individually until finding a willing buyer, thus making for a very onerous system indeed. Instead, the secondary financial market offers a place where open buying and selling can occur.