Lesson 1.2: Secondary Markets
Secondary Markets and Their Importance
Secondary markets facilitate trading between buyers and sellers of securities, supporting primary markets.
Without secondary markets (e.g., stock exchanges), few would own stocks; easy selling at a fair price is crucial.
Secondary markets enable corporations to raise capital by issuing securities.
They promote economic expansion and job growth.
As a BD representative, you are vital in helping customers achieve financial goals while supporting the economy.
Liquidity
Liquidity is the ability to easily buy or sell a security.
Secondary markets provide liquidity to investors.
Liquid securities (e.g., Treasury bills, exchange-listed stocks) are easily sold with little liquidity risk.
Illiquid securities (e.g., limited partnership units) are difficult to liquidate.
Primary vs. Secondary Markets
In primary markets, the seller is always the issuer.
In secondary markets, the seller is never the issuer. Investors sell securities and keep the money.
Market Centers
Definition
Market centers are physical or electronic locations where buyers and sellers gather to trade.
Types of Market Centers in the U.S.
Exchanges
OTC (Over-the-Counter)
Nasdaq
ECNs (Electronic Communication Networks)
Exchanges
Composed of the NYSE and other exchanges where listed securities are traded.
Also known as an auction market.
Listed security: Any security listed for trading on an exchange.
The NYSE is the largest exchange and a common model for understanding exchanges.
Companies must meet specific criteria to be listed on an exchange.
Characteristics of Exchanges
Physical Location:
Exchanges typically have a physical location or floor.
Members transact business on the floor.
Pricing System:
Exchanges are double-auction markets. Buyers and sellers call out bids and offers to get the best price.
Members of the Exchange
Designated Market Maker (DMM):
Acts as a dealer for specific securities.
Maintains an inventory of the security and guarantees liquidity.
Responsible for maintaining a “fair and orderly” market.
Floor Broker:
Represents their firm and clients on the floor.
Handles trades that execute on an exchange.
Two-Dollar Broker:
Enlisted when floor brokers are overwhelmed.
Places trades for floor brokers for a fee.
Floor Traders:
Buy and sell on the floor for their firm's accounts.
Help maintain liquidity.
Important Notes
Trading occurs between members, not employees.
Employees support the exchange and its members but do not trade.
There are over a dozen registered exchanges in the U.S., but the NYSE serves as the model.
Over-the-Counter (OTC) Market
The OTC market also has criteria for companies to be traded, similar to exchanges.
Historically, OTC criteria were less stringent, but the gap has narrowed.
It remains the market center for smaller companies.
It trades unlisted stocks, most bonds (including municipal and Treasury debt in secondary markets).
Most corporate debt issues trade OTC.
Trading occurs between market makers in a decentralized electronic market.
No physical location or “floor.”
Market Makers
A BD that maintains an inventory in a given security and buys/sells it.
Similar to DMMs on exchanges, but multiple market makers compete in the same security.
When a customer places an order with a BD for an OTC security, the broker chooses a market maker to complete the trade and get a fair price.
Customer sells to a dealer (through the BD) at the bid price.
Customer buys from a dealer (through the BD) at the ask price.
The spread (bid-ask difference) is the market maker's income.
Quotes represent the highest bid and lowest ask.
Third Market (Nasdaq Intermarket)
Trading market where exchange-listed securities are traded in the OTC market.
BDs registered as OTC market makers in listed securities can trade in the third market.
All securities listed on the NYSE and most regional exchanges are eligible for OTC trading if trades are reported to the Consolidated Tape within 10 seconds.
Fourth Market (ECNs)
Market for institutional investors.
Large blocks of stock (listed and unlisted) trade in transactions unassisted by BDs.
Trades take place through Electronic Communication Networks (ECNs).
ECNs are open 24 hours a day.
Dark Pools
Dark pools are trading (liquidity) not openly available to the public.
Bulk of volume represents trades by institutional traders away from exchange markets.
Typically large-volume transactions.
Institutional trading desks use dark pools to execute large block orders without impacting public quotes or revealing their investment strategy.
Orders can be placed anonymously.
Concern: Some market participants are disadvantaged because they cannot see trades, volume, or prices, reducing market transparency.
Trading Hours
NYSE trades between 9:30 am and 4:00 pm ET each business day.
Normal OTC hours match NYSE hours, though many market makers stay open until 6:30 pm in extended hours trading.
The after-hours market is less liquid, with wider spreads and greater price volatility.
Participants in Secondary Markets
Broad Categories:
Investors
Facilitators
Investors
Buy and sell securities to accomplish their objectives.
The seller is not the issuer in most secondary market transactions.
Exception: Buybacks, where the issuer buys the security from investors.
Types of Investors:
Retail Investors:
Normal people investing their own money.
Can be of modest means or very wealthy.
Generally not professional investors.
Rules on disclosure, communications, and recommendations are designed to help them.
Day Trader:
A type of retail investor that trades rapidly.
Closes all positions and ends the day flat (no positions).
Accredited Investors:
Classification used in primary market transactions.
The term has no specific use in secondary markets, but it is sometimes used to identify a wealthier or more sophisticated retail investor.
Institutional Investors:
Large investors like mutual funds, pension funds, banks, insurance companies, or other financial service organizations.
Investment decisions are made by professionals (e.g., investment advisers).
Fiduciaries: Custodians and Trustees
Manage accounts for others.
Fiduciary: Manages assets for another person (beneficiary).
Legal and moral obligation to act in the beneficiary's best interest, placing their interest before their own.
Custodian:
Manages a minor's account under UTMA/UGMA.
May also refer to a firm holding assets in a qualified retirement account (e.g., IRA).
Trustee:
Oversees a trust (living trust, pension trust, etc.).
Guardians and executors:
Guardians are court-appointed custodians over a minor or incapacitated adult.
Executors are custodians of estates.
Investment Advisers (IAs)
Three-prong test:
Gives investment advice.
As a regular part of their business.
Does so for compensation.
Must register as an IA under the Investment Advisers Act of 1940 and the Uniform Securities Act.
BDs who provide advice for a fee are subject to registration.
Agents of IAs must register and pass the Series 65 or Series 66 exam (for representatives with a Series 7).
When acting as an IA, the adviser is acting as a fiduciary for a customer.
Dual Registration
An RR who charges commissions for transactions wants to charge separately for investment advice.
They would need to register as an investment adviser representative (IAR) by passing the appropriate exam (Series 65 or 66), even if already registered under the Securities Exchange Act of 1934.
When acting as an IA, the IA represents the customer. If the same firm is also a BD, it can also place the trade but is acting in its BD capacity when executing a trade.
The representative will be dual registered (as an IA representative and as an RR) and will be working for a dually registered firm (IA and BD).
Facilitators
Help customers perform transactions in the secondary markets.
Broker-Dealers (BDs)
FINRA member firms that perform securities transactions for their own accounts or for their customers.
Revenue comes from transaction fees like commissions and loads.
Each BD operates under an individualized membership agreement with FINRA (and possibly other SROs).
Firms (and associated persons) may never state that they are endorsed, approved, or recommended by a regulator.
Some BDs offer all types of investment products; some limit the products they offer.
BDs can incorporate proprietary trading (trading the firm's own capital).
Some publish quotes to buy and sell securities and are known as market makers.
Most firms service retail customers, but some specialize in dealing solely with institutional investors.
Types of BD Firms:
Carrying Firms (Clearing Firms):
Carries customer accounts and accepts funds and securities from customers.
Typically larger BDs.
Can do trade executions, clear and settle transactions, take custody of customer funds and securities, and handle all back-office tasks.
Required to maintain higher net capital levels.
Must segregate customer funds and securities from the firm's own.
Fully Disclosed (Introducing) Firms:
Introduces its customers to a clearing firm.
The clearing firm holds funds and securities and performs related functions.
Lower net capital requirements.
May take orders but the settlement (clearing) of the trade falls to the clearing firm.
Prime Brokers:
Provide custody and other services for institutional customers.
The customer selects one member firm (the prime broker) to provide custody and other services, while other firms (called executing brokers) may handle certain trades.
The prime broker must sign an agreement with the customer, spelling out the terms of the business relationship and names of all executing brokers.
The prime broker will then enter into written agreements with each executing broker named by the customer.
The customer receives trade confirmations and account statements from the prime broker, who facilitates clearance and settlement.
Responsibility for compliance with certain trading rules rests with the executing brokers.
Key Advantages of Prime Brokerage Accounts:
Ability to trade with multiple brokerage houses while maintaining a centralized master account.
Often includes specialized services like securities lending, margin financing, trade processing, cash management, and operational support.
Likely to be offered to more active trading clients (e.g., hedge funds).
Broker vs. Dealer
BDs make money from processing transactions.
A BD may act as a broker or as a dealer on a transaction, but they may never be both on the same transaction.
Transfer Agents
Transfer and registration of stock certificates are two distinct functions that cannot be performed by a single person or department.
Issuers typically use commercial banks and trust companies to handle these functions.
The transfer agent for a corporation is responsible for:
Ensuring that its securities are issued in the correct owner's name.
Canceling old and issuing new certificates.
Maintaining records of ownership.
Handling problems relating to lost, stolen, or destroyed certificates.
Registrars
Always a separate firm than the issuer or a transfer agent.
Licensed by the states and provide audit and oversight services for the transfer agents.
The transfer agent maintains a count of the total number of shares of a company that are authorized and outstanding.
Depositories and Clearing Agencies
A clearing agency (or clearing corporation) is an intermediary between the buy and the sell sides of a transaction.
Receives and delivers payments and securities on behalf of both parties.
Any organization that fulfills this function is considered a clearing agency.
Conceptually similar to how a bank clears checks between two parties.
Commercial banks, corporations, and securities depositories can act as clearing agencies.
The Depository Trust and Clearing Corporation (DTCC) is the world's largest securities depository.
Provides custody services for virtually all securities except restricted securities.
Depository Trust and Clearing Corporation (DTCC)
The DTCC is a member of the Federal Reserve System and is not in the retail banking business.
Provides automated clearing and settlement services in a book-entry format to banks and BDs for stock and bond trades.
Employs a continuous net settlement (CNS) system.