In terms of the economy, the secondary market is very fundamental because it will allow the already issued securities to be traded and ensure liquidity. It also serves to facilitate the discovery of price through investment for any market participant; securities such as stocks, bonds, derivatives, and other securities are bought and sold here once they have already been issued on a primary market. The secondary market is the backbone of a strong economy as a well-functioning financial system. In the secondary market, unlike the primary market where the first issue of securities takes place, securities are traded among investors. This provides liquidity and offers a mechanism for pricing securities efficiently. Knowing what is the main function of secondary market provides an explanation of its impact on the market participants and on the economy.
The secondary market is the financial marketplace whereby investors trade securities they already hold. It comprises of the orderly exchanges, for example, a stock market and over-the-counter exchanges. It enables individuals to purchase and sell shares, bonds, and other financial instruments independently of the original issuer of the securities. The secondary market is where previously issued securities like stocks, bonds, and derivatives are actively traded among investors. It plays a pivotal role in the financial ecosystem by providing liquidity, enabling price discovery, and fostering investor confidence. Understanding its dynamics helps grasp how financial markets support economic growth and investment opportunities.Â
Features of Secondary Market
The secondary market is a critical segment of the financial system where investors trade existing securities. Its primary features include liquidity, enabling investors to buy and sell assets with ease, and price discovery, where market forces determine the fair value of securities
Liquidity Facilitating: It enables investors to easily liquidate investments by selling in the secondary market.
Price Discovery: Regular trading ensures that securities are priced fairly based on demand and supply.
Accessibility for Investors: The market provides an avenue for retail and institutional investors to participate and diversify their portfolios.
Instruments in the Secondary Market
The secondary market accommodates various types of financial instruments, categorized broadly into equity, debt, and derivative products.
Equity Securities: Equities represent ownership in a company. The most commonly traded equity instruments are:
Common Stocks: They give owners voting rights and the right to claim dividends. Fixed dividends are payable, but often no voting rights.
Debt Instruments: Fixed-income products in the secondary market.Obligations raised by corporations for running their businesses.
Derivatives: Derivatives derive value from an underlying asset. Popular derivatives include:
Futures: It is a form of contract, obligating an individual to purchase/sell some assets at some future date.
Options: It provides the right but not the obligation to buy or sell assets.
What is the Main Function of Secondary Market?
The main function of the secondary market is to provide liquidity and a platform for trading existing securities such as stocks, bonds, and other financial instruments. It enables investors to buy and sell these securities among themselves after their initial issuance in the primary market. This market enhances the overall efficiency of financial systems by ensuring a continuous trading mechanism, thereby facilitating price discovery through the forces of demand and supply. Additionally, it allows investors to convert their holdings into cash quickly and supports companies indirectly by reflecting their stock performance, which can impact their credibility and future capital-raising efforts​​. The secondary market performs several essential roles in financial systems
Liquidity Creation
Definition: Liquidity refers to the ease with which assets can be converted into cash without significantly impacting their market price.
Importance: The secondary market allows investors to quickly buy or sell securities, ensuring they are not locked into their investments indefinitely. This enhances market efficiency and attracts more participants.
Impact: High liquidity ensures minimal price volatility and fosters investor confidence in the market’s stability.
Price Discovery
Mechanism: The secondary market facilitates continuous trading that determines securities’ fair market value. Prices are subject to real-time dynamics of supply and demand.
Benefits:
It helps investors make informed decisions about buying, holding, or selling securities.
It reflects market sentiment, economic conditions, and the performance of companies.
Facilitating Capital Allocation
Role: The secondary market enables the transfer of securities, directing funds to the most promising investment opportunities.
Outcome: The resources are best utilized, hence economic growth and innovation, as capital flows to enterprises with the potential for higher returns.
Diversification of Risk
Process: The investors can trade various classes of assets in the secondary market such as equities, bonds, and derivatives.
Benefits: Facilitates investors to construct diversified portfolios.The impact of poor performance from any single investment is reduced hence reducing the overall risk.
Investor Confidence Building
Transparency: Secondary markets operate under strict regulatory oversight, ensuring fair trading practices and price transparency.
Trust: Such features attract more participants, thus creating a virtuous cycle of greater liquidity and price efficiency.
Continuous Trading Platform
Function: It enables the uninterrupted buying and selling of securities, which allows investors to trade at any time during market hours.
Importance: It gives investors the chance to react to changes in the market, news, and events such as economic reports, company announcements, or geopolitical events.
Advantage: Ensures that financial markets operate without interruption, hence contributing to economic stability.
Promoting Savings and Investment
Role: The speed and fair prices at which securities can be sold encourage individuals and institutions to invest their savings in financial instruments.
Result: Savings are mobilized effectively into productive investments, hence promoting economic growth.
Benchmarking Company Performance
How It Works: Stock prices in the secondary market reflect the performance and perceived future potential of companies.
Impact: Companies with consistently high stock prices gain credibility, which can:
Company Insight: It provides a form of feedback for companies through assessing their strategies and operational efficiency.
Smoothing Entry and Exit
For Investors: Allows for smooth entries and exits in investments, which are always preferred. It allows portfolio partial liquidation in adjustment of cash needs or even investment rebalancing.
For Companies: Confirms to the prevailing market conditions that guide companies in deciding whether to issue more shares or bonds.
Types of Secondary Market
The secondary market can be classified into two major categories;
Stock Exchanges: Organized platforms like New York Stock Exchange (NYSE) or Bombay Stock Exchange (BSE) where securities are listed and traded.
Over-the-counter (OTC): A decentralized network where securities are traded directly between parties without a central exchange. Key aspects include:
Merits of the Secondary Market
The secondary market has several advantages that contribute to the financial ecosystem:
Liquidity: Allows easy conversion of securities into cash. It opens up avenues for small and large investors.
Fair Pricing: Continuous trading ensures fair value determination. It allows diversification across different securities. It facilitates efficient capital allocation, boosting productivity.
Demerits of the Secondary Market
Despite its advantages, the secondary market has its challenges
Price Volatility: Rapid trading can lead to unpredictable price swings. Over-speculation can lead to market instability.
Market Manipulation: Susceptible to fraudulent practices, especially in the less-regulated OTC markets. Brokerage fees and other commissions can lower the net returns for investors.