1.4 Types of Markets

Securities markets come in different flavors. Understanding how they're organized - and how they differ - is fundamental knowledge for the SIE exam.

Primary vs. Secondary Markets

The most fundamental distinction in securities markets is between primary and secondary markets.

Primary: New securities are issued and sold for the first time; Issuers raise capital

Secondary: Previously issued securities trade between investors; Investors gain liquidity

The Primary Market

The primary market is where securities are born. When a company or government issues new securities, they sell them in the primary market to raise capital.

Key Characteristics

- Issuer receives proceeds - Money goes directly to the company or government issuing the securities

- One-time transaction - Each security is sold in the primary market only once

- Underwriters facilitate - Investment banks typically help issuers sell their securities

Types of Primary Market Offerings

Initial Public Offering (IPO): A private company sells shares to the public for the first time

Follow-on Offering: A public company issues additional shares

Rights Offering: Existing shareholders get first right to buy new shares at a discount

Private Placement: Securities sold directly to a small group of investors

Example: IPO Process

When a company like Acme Corp goes public:

1. Acme files a registration statement (Form S-1) with the SEC

2. Investment banks underwrite the offering and set the initial price

3. Shares are sold to institutional and retail investors

4. Acme receives the proceeds (minus underwriting fees)

5. After the IPO, shares trade on the secondary market

The Secondary Market

The secondary market is where investors trade securities with each other. The issuing company doesn't receive any money from secondary market transactions.

Key Characteristics

- Provides liquidity - Investors can convert securities to cash

- Price discovery - Market forces determine what securities are worth

- Continuous trading - Unlike the one-time primary market sale

Why It Matters

Without a secondary market, investors would be hesitant to buy securities in the primary market. Knowing they can sell later makes investors more willing to invest upfront.

Auction Markets vs. Dealer Markets

Secondary markets can be organized in two fundamentally different ways:

Price Setting: Auction Market - Buyers and sellers compete; Dealer Market - Dealers quote bid/ask prices

Intermediary: Auction Market - Minimal, buyers meet sellers; Dealer Market - Dealers trade from inventory

Example: Auction Market - New York Stock Exchange (NYSE); Dealer Market - NASDAQ

Also Called: Auction Market - Exchange market; Dealer Market - Over-the-counter (OTC) market

Auction Markets

In an auction market, buyers and sellers come together to compete on price. The highest bidder and lowest seller are matched.

How It Works

1. Buy orders specify the maximum price a buyer will pay (bid)

2. Sell orders specify the minimum price a seller will accept (ask)

3. Matching occurs when bid and ask prices meet

4. Price discovery happens through open competition

The NYSE as an Auction Market

The New York Stock Exchange operates as an auction market with Designated Market Makers (DMMs) who:

- Maintain fair and orderly markets in assigned stocks

- Step in to buy or sell when there's an imbalance

- Help facilitate price discovery

Dealer Markets

In a dealer market, dealers (also called market makers) quote prices at which they'll buy and sell securities from their own inventory.

How It Works

1. Dealers post quotes - Bid price (what they'll pay) and ask price (what they'll charge)

2. Investors trade with dealers - Not directly with each other

3. Spread is the profit - Dealers earn the difference between bid and ask

NASDAQ as a Dealer Market

NASDAQ operates as a dealer market where:

- Multiple market makers compete on each stock

- Electronic systems match trades

- Competition among dealers keeps spreads tight

Bid-Ask Spread Example

A market maker quotes: $49.90 bid / $50.10 ask

- They'll buy shares from sellers at $49.90

- They'll sell shares to buyers at $50.10

- The $0.20 spread is their potential profit per share

Fourth Market: Direct Trading

The fourth market refers to direct trading between large institutional investors, bypassing both exchanges and dealers entirely.

Characteristics

- No intermediaries - Institutions trade directly

- Lower costs - No commissions or spreads

- Dark pools - Private exchanges where large trades can execute without moving the market

- Block trades - Large transactions (10,000+ shares)

Market Structure Summary

Primary: Participants - Issuers to Investors; Key Feature - New securities issued

Secondary: Participants - Investor to Investor; Key Feature - Trading existing securities

Auction: Participants - Buyers vs. Sellers; Key Feature - Competitive bidding

Dealer: Participants - Investors to Dealers; Key Feature - Market makers quote prices

Fourth: Participants - Institution to Institution; Key Feature - Direct trading

Key Takeaways

- Primary markets are where issuers sell new securities to raise capital

- Secondary markets provide liquidity for investors to trade existing securities

- Auction markets (like NYSE) match buyers and sellers through competitive bidding

- Dealer markets (like NASDAQ) use market makers who trade from inventory

- Understanding market structure helps explain how prices are set and trades execute