Primary vs. Secondary Markets: Understanding the Key Difference

The trading of American financial securities, commodities, derivatives, and other financial products occur on stock exchanges. A stock market is required for initial public offerings (IPOs) by publicly traded companies, successful start-ups, and other entities that function on a shareholder basis. To begin with, the words “primary market” and “secondary market” are separate. In contrast to the secondary market, where securities are sold between investors, the primary market is where securities are created. From this article, we can get a better understanding of the primary market, secondary market, features of the primary market, features of the secondary market, and the differences between the primary market and secondary market.

Primary market and secondary market

Primary markets, often called gateway markets, are composed of sizable, densely populated areas with a long history of commerce and industry. Investors can acquire and sell securities they already possess on the secondary market.

What is the primary market?

In a primary market, new securities are issued. Financial asset businesses, governments, and other organizations use a debt or equity-based security. Investment banks manage the selling of securities to investors on the primary markets and determine the starting price range for securities. For the first time, new stocks and bonds are “floated” (in finance parlance) by companies in this market. Companies and governmental bodies sell new shares, bonds, notes, and bills on the primary market to raise money for improvements and expansions to their businesses.

The issuer receives the majority of the proceeds, even if an investment bank may determine the securities’ initial price and be compensated for facilitating sales. The primary market is more focused on the products themselves than a physical place would be.

In contrast to being purchased from a prior buyer, or “second-hand” securities are bought directly from an issuer in a primary market, which is one of its essential qualities. A tight set of rules governs all.

How does the primary market work?

Corporations often issue new securities on the primary market to raise money for long-term capital requirements. Public issue refers to issuing shares to the general public and the firms that issue them. Here’s how the primary market works:

• Preparing and filing the offer document – An offer document contains any necessary information about the company, financials, terms of the issue, and goals for raising funds. Any company seeking to raise money from the public needs to prepare and file the offer document.
• Opening the issue – After completing the necessary legal procedures, the issuer corporation publishes advertisements. The issue is then available for subscription to the general public. Suppose the potential investor is interested in purchasing shares of the issuer company based on information in the offer document. In that case, he may do so by properly completing the application form and making the required payment before the issue closes.
• Allotment – The shares are then allocated to the applicants after the closing date. If there is an oversubscription, the allotment will be done on a lottery basis.

Functions of the primary market

The primary market is a market for creating long-term capital. Such a market serves a variety of objectives:

• Offer for new issues – New issues that have not been traded on other exchanges may be offered on a primary market. Setting up a new issue market entails, among other things, carefully assessing the project’s viability. Therefore, a new issue market is often called a “fresh issue market”. The promoters’ equity, liquidity ratio, debt-to-equity ratio, and foreign exchange needs are considered when the project’s financial arrangements are formed expressly.
• Providing underwriting services – Underwriting is essential when starting a new issue. If the firm cannot sell the required number of shares, underwriters purchase unsold shares in a main market. Financial institutions that take on the role of underwriters can receive underwriting commissions. Investors look to underwriters to help decide whether taking risks and earning rewards is worthwhile. Underwriters can buy IPOs and then sell them to investors.
• Distribution of new issues – New issues are dispersed throughout a significant marketing area. The issuance of a new prospectus marks the beginning of these payouts. It invites the general public to purchase a new issue and comprehensive details on the issue, underwriters, and firm.

Pros and cons of the primary market

As everything has its pros and cons, the primary market also has its advantages and disadvantages. Let us look into its pros and cons:

Pros

• Companies can raise capital for a reasonable price. The securities issued in the primary market have high liquidity since they can be sold in the secondary market.
• Primary markets play a crucial role in an economy’s ability to mobilize savings. Savings from the community are tapped into investment in different ways. This is used to finance investment options.
• The primary market has much lower odds of price manipulation than the secondary market. By deflating or inflating a security’s price, manipulations like this impact the fair and free operation of the market.

Cons

• Each stock has a different level of risk, but since the company is issuing its shares through an IPO for the first time, there is no previous trading data for IPO shares to analyse.
• It might not always be advantageous for small investors. If a share is oversubscribed, allocations to small investors might not be made.

What is the secondary market?

A “Secondary market” is a financial platform where investors can buy and sell securities like bonds and shares. Because transactions occur between secondary investors after the primary market, the secondary market is often referred to as the aftermarket. In contrast to the main market, the secondary market is where trading via follow-on public offerings takes place. Trading occurs in the primary market for the first time through an IPO. Some examples of secondary markets are NASDAQ and the London Stock Exchange. Because the transactions occur after the Initial Public Offer, it is also known as a follow-on public offering (IPO).

How does the secondary market work?

Investors in secondary markets trade with one another rather than the issuing entity. The secondary market drives the price of securities toward their true value through a massive series of independent yet interconnected trades. A secondary transaction occurs when shareholders of a private venture capital-backed company sell their stock to an investor. Its worth is determined by calculating the stakes’ Net Assets Value (NAV). A secondary transaction can take several forms:

• A sale transaction made by an early investor involving the company stock to a third party
• In the event of a company’s insolvency, liquidation for the founders as part of a financial round
• If a company grants employee stock options, the options must be exercised.

Functions of the secondary market

The secondary market serves the following purposes:

• Maintaining the fair value of stocks – The secondary market achieves an equilibrium point (the point where demand equals supply) with the help of demand and supply in the market, which leads to the fair value of stocks.
• Portfolio Adjustment – The secondary market assists investors in selecting shares for buying and selling, which leads to the development of a solid portfolio.
• Capital Allocation – Secondary Markets aid in capital allocation by signaling the prices of shares that is yet to be released from the Primary Market to the Secondary Market.

Pros and cons of the secondary market

Let us have a look into the pros and cons of the secondary market:

Pros

• Secondary markets assist businesses in determining their worth.
• The secondary market is an excellent indicator of a company’s current fair valuation.
• When new information about the company becomes available, the price of securities adjusts quickly.
• The secondary market promotes economic efficiency.

Cons

• Cash flows for Secondary Market loans may be irregular.
• Understanding the Premium Cost may be challenging.
• Recognizing opportunity costs is also a tough task.

Difference between primary and secondary market

With a detailed understanding of the primary market and secondary market, now let us look into the contrasting points between these markets.

Comparison chart of primary and secondary market

Key differences of primary and secondary market

As enumerated above, a wide range of differences exist between a primary market and secondary market. They are two different terms. Some of the key differences between these two terms are explained below with the help of some examples.

The secondary market is where these securities are traded, whereas the primary market is where securities are formed. The main market is where a business raises money for the first time. For instance, businesses only conduct Initial Public Offerings (IPOs) on the primary market. The secondary market lists the company’s primary market-issued shares. The secondary market includes all exchanges like NASDAQ, NYSE, German DAX, etc.

As an illustration, Company ABC Limited employs underwriting companies to ascertain the financial specifics of its IPO. The underwriters specify that the stock would be issued at a price of Rs.1000. Investors may directly purchase shares of this IPO at this price. It is known as a primary market since this is the initial chance that investors have to invest money in a firm by purchasing its stock.

As another illustration, if you purchase stock in Amazon, you will only be interacting with other shareholders of Amazon. The transaction does not include Amazon directly. The term secondary market refers to this.

In other words, the secondary market is the market that deals in securities that have already been issued by the corporation, whereas the primary market provides avenues for selling new securities to investors.

The primary market deals with Initial public offering (IPO) and Follow on public offer (FPO), whereas the secondary market deals with Shares, Debentures, Warrants, Derivatives, etc.

When it comes to beneficiary, in a primary market the company is the beneficiary whereas in a secondary market the investor is the beneficiary.

Importance of secondary transactions in cap table

All of a company’s securities, including common and preferred shares, options, SAFEs, convertible notes, and warrants, are listed in a cap table. Additionally, it displays each investor’s current ownership percentage, the value of their stakes, and how much of each security type they own now.

As we infer from the paras mentioned above, the proceeds of each sale on the secondary market are paid to the selling investor, not to the firm that issued the shares or to the underwriting bank, and all transactions occur between investors.

Here, to have control on the secondary transactions, it is necessary to list them in a cap table. Also, secondary transactions offer the company an opportunity to clean up the cap table without a new funding round.

So, be it a startup or a huge organization, centralizing data and keeping track of shareholders and equity is essential for making informed decisions and for the company’s value.

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