Types of Secondary Markets
Types of Secondary Markets
The two major types of secondary markets are exchanges and over-the-counter markets.
Over-The-Counter Markets (OTC)
An over-the-counter market is a decentralized place where members are trading amongst themselves. Dealers in OTC markets act as market-makers by quoting prices at which they want to buy and sell a security. A trade between two participants can be executed without other participants being aware of the price of the transaction. There’s high competition among the participants to get higher volumes, meaning that the price of securities may vary from seller to seller.
The term “over-the-counter market” originally referred to the off-Wall Street trading that exploded during the bull market of the 1920s, where shares were sold “over-the-counter” in stock shops and were not listed on a share exchange.
Over-the-counter markets do not have physical locations. Traders can place orders through electronic listing services like the Over-the-Counter Bulletin Board (OTCBB) and the OTC Markets Group (previously known as Pink Sheets). These networks of brokers usually describe themselves as providers of price and liquidity information for over the-country securities. In general, OTC markets are typically less transparent than exchanges and have fewer regulations to comply with than stocks traded on a stock exchange. Also, the counterparty risk is high in OTC markets as parties deal with each on one-to-one basis.
An example of the OTC market is the Foreign Exchange Market (FOREX).
An exchange is a market where people meet to trade securities. Exchanges serve to ensure fair and orderly trading and to provide reliable price information for the securities trading on that exchange. Exchanges operate under heavy regulations to guarantee that all trades are legal, secure, and transparent and the probability for counterparty risk is very low.
The secondary market can be further broken down into auction markets and dealer markets.
An auction market is a market with a fixed location that facilitates trading and liquidity by matching buyers and sellers for a specific security. Investors and institutions who wish to trade securities enter the prices at which they are willing to buy (the bid price) and sell (the ask price) at the same time. When a buyer’s price and a seller’s asking price match, the bid and offer are paired together to execute an order. The price at which a stock trades represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept. The underlying idea behind the auction secondary market is that the convergence of buyers and sellers will bring out mutually agreeable prices.
A typical example of an auction market is the New York Stock Exchange (NYSE).
The dealer secondary market is where investors trade with dealers, who are also known as market makers. Dealers provide liquidity and transparency by electronically displaying prices at which they are willing to buy and sell a particular stock. These prices are referred to as the bid price and the offer price.
Dealers often sell their stocks at a price greater than the bid price they pay. The difference between these two prices, called the bid-ask spread, enables dealers to earn profits while ensuring the liquidity of an immediately available market to occasional participants. This also pays for the risk that prices could decline while dealers are holding the securities.
Dealer markets don’t require parties to converge in a central location. Rather, participants in the market are joined through electronic networks. At that, investors operating in dealer markets may have to search for the dealer offering the best price. The theory behind dealer markets is that competition encourages dealers to provide the best possible prices for investors.
A typical example of a dealer market is the NASDAQ.