The role of the secondary market is important in providing liquidity, price discovery, and opportunities to trade existing securities. It provides for the buying and selling of stocks, bonds, and other financial instruments after they have been issued in the primary market. Creating such an environment that might be dynamic to support economic growth, ensure fair pricing, and boost investor confidence becomes all the more feasible through the secondary market due to its facilitation of the trading of financial assets. In this article, the concept, functions, and types of the secondary market have been elaborated in great detail along with its role in a robust financial system.
What is Secondary Market?
The secondary market is a marketplace where investors sell and buy financial instruments such as stocks, bonds, and other securities. This is also termed the Aftermarket since this is where the second stage of the financial instruments takes place after their first issue in the primary market. Here, trading occurs among traders and other investors instead of the entities issuing their securities. Typically, most people think of the stock market as the secondary market.
Role of Secondary Market
The role of secondary market is multifaceted, benefiting both investors and the overall economy. By providing a platform for trading securities, it creates a vibrant financial ecosystem where funds are efficiently allocated, and market participants can achieve their investment goals.
Provides Liquidity
The secondary market offers some liquidity, permitting investors to make a buy order or sell out whenever they see the need and desire. Through this easy trading that provides confidence on the part of investors, one attracts more in the financial marketplace.
Liquidity ensures speed in accessing funds by any investor. Hence, it brings about quickness in the reinvestment of money towards capital flow activities, which again enhances market actions.
Price Discovery
The secondary market is where the fair value of securities is determined by demand and supply. As a result, prices reflect stocks’ real-time worth.
Stock prices represent insight into firm performance, market activity, and the overall economy. Hence, accurate price discovery fosters transparency for shrewd investor decisions.
Facilitates Ownership Transfer
The secondary market allows easy transfer of ownership between investors. In this scheme, the aspect of buying and selling securities is made therefore smooth and effective, hence allowing investors to trade at their convenience. Through this, the process supports investor confidence and facilitates participation.
This smooth exchange keeps securities active and in circulation. A dynamic market environment arises since trading does not cease to be constant. This activity raises liquidity, hence facilitating quick fund access for investors and the overall well-being of the financial market.
Encourages Investment
This secondary market provides an easy entry as well as exit, making it perfect for short-term and long-term investments. The convenience provided by such a wide range of investors attracts individuals to be active in the financial market.
Due to flexibility, this secondary market ensures people invest their funds instead of keeping it idle, thus promoting financial growth and contributing to economic development.
Boosts Economic Growth
A well-functioning secondary market accelerates economic growth by mobilizing resources effectively towards productivity use. It means that capital is kept active and supports various sectors of the economy.
A good working secondary market indirectly helps businesses gain access to capital by instilling confidence in investors in trading securities. This process enhances the strength of the financial system and promotes overall economic development.
Types of Secondary Market
The secondary market can be broadly classified into two types based on the nature of transactions and trading platforms.
Stock Exchange
The Stock Exchange is the name given to a centralized platform where securities are traded. Investors trade with other investors without knowing them personally. Only the price of the securities matters for either buying or selling them. There are strict regulations given by SEBI (Securities and Exchange Board of India) which the exchanges should follow and should list securities for trading which are trustworthy.
For trading, thus for investors exchanges would be the safest option. Using the services of stock exchanges may be available in exchange charge as well as with a provision for commission. Among them are: the Bombay Stock Exchange (BSE), the National Stock Exchange of India(NSE).
Over-the-Counter (OTC) Market
The OTC market deals with individual investors or participants. It is different from the stock exchange as the OTC market is a decentralized platform. Here, the risk is high as they lack stringent rules and regulations. The competition of investing is high and investors try to accumulate higher volumes of stocks for future trading. This results in price fluctuations among participants. A broker-dealer relationship persists.
The stocks of the companies that could not fulfill any criteria to become a part of the stock exchange are listed on the OTC market. Examples include foreign exchange; OTCEI over-the-counter exchange of India; Pink sheets; and OTCQB-Venture market, among others. Under the OTC market, a part is also assigned to the derivative markets. Derivative markets are those in which underlying assets or commodities are put as stock-for example, oil, rice, coal, etc.
Different Instruments in Secondary Market
The constituents of a secondary market are fixed-income instruments, variable-income instruments, and hybrid instruments.
Fixed Income Instrument
Fixed income instruments are essentially debt instruments that guarantee a regular form of payment such as interest, with the principal being paid at maturity. Examples of fixed-income securities are- debentures, bonds, and preference shares.
Debentures are unsecured debt instruments, i.e., not secured by collateral. Returns generated from debentures are thus dependent on the issuer’s credibility.
A bond is an agreement between two parties, which may be a government or a company, issuing this financial instrument. By purchasing these bonds, the issuer entity can raise huge amounts of money. The issuer pays interest periodically and returns the principal amount when the bond reaches maturity.
People who have preference shares in a company get paid the dividend before any equity shareholder is paid. If a company goes into bankruptcy, then the preference shareholders are paid before other shareholders.
Variable Income Instrument
Investment in variable income instruments generates an effective rate of return to the investor, and various market factors determine the quantum of such return. These securities expose investors to higher risks as well as higher rewards. Examples of variable income instruments are – equity and derivatives.
Equity shares are instruments that enable a company to raise finance. Apart from this, investors with equity shares have a claim over the net profits of a company along with its assets in case the latter goes into liquidation.
Derivatives are, on the other hand, a kind of contractual obligation between two different parties involving pay-offs for some specified performance.
Hybrid Instrument
A combination of two or more different financial instruments is formed to be used as hybrid instruments. Hybrid instruments include convertible debentures.
Convertible debentures are offered in the form of a loan or debt securities, and after a definite period, the same may be converted into equity shares.
Role of Secondary Market FAQs
What is the role of secondary market in the financial system?
The secondary market provides liquidity, facilitates price discovery, and enables ownership transfer, thereby supporting efficient resource allocation in the financial system.
What are the types of secondary market?
There are two types of secondary markets, namely stock exchanges (e.g., NSE, BSE) and over-the-counter (OTC) markets.
What are the functions of secondary market?
The roles involved are to offer liquidity, price discovery, safe transfer of ownership, and promotion of investment.
What is the Role of SEBI in Secondary Market?
SEBI governs the secondary market by making sure that increased transparency, no fraud as well as securing the interest of the investor.
Why Liquidity is Important to Securities Market?
Liquidity ensures that the investor can sell or buy the securities easily, and the funds are not being locked up and can be re-invested.
