Basic Functions of the Secondary Market
Basic functions of the secondary market. When securities are traded between investors, issuers no longer receive any cash proceeds. Investors usually initiate securities purchases in the secondary markets by calling a security brokerage house. After an account has been opened, a broker relays the client’s order to a dealer making a market in the securities the investors want. Since the secondary market involves the trading of securities initially sold in the primary market, it provides liquidity to the individuals who acquired these securities.
The primary market benefits greatly from the liquidity provided by the secondary market because investors would hesitate to purchase securities in the primary market if they could not subsequently sell them in the secondary market.
However, the basic functions of the secondary market may be summarized below:-
Providing a market placing –
A stock exchange provides a market place for purchasing and selling securities in the secondary markets. Investors would be able to buy and sell securities at any time, as stock exchange provides the facility for continuous trading in securities like shares, bonds, debentures etc.
Continuous/active trading –
Secondary markets maintain active trading so that investors can buy or sell immediately at a price that varies little from transaction to transaction. A continuous trading increasing liquidity of the assets traded in the secondary markets.
Providing liquidity –
An organized stock exchange provides the investors with a place to liquidate their holdings meaning that securities can be sold in the stock exchanges at any time.
Media of asset pricing –
Security price is determined by the transaction that flow from investor’ demand and supply preferences. This market usually makes their transactions prices public that helps investors make better decisions.
Stimulate new financing –
If the investors can trade their securities in a liquid secondary market, they will be encouraged to invest in IPOs that will directly help the issuing authority to collect new finance.
Monitoring activities –
Being self-regulatory organization a secondary market can monitor the integrity of members, employees, listed firms, clients, and other related bodies/persons.
Provide risk premium –
Without an active secondary market, the issuers would have to provide a much higher rate of return to compensate investors for the substantial liquidity risk.
An indicator of the economy –
An organized stock plays the role as an indicator of the state of health of the economy of a nation as a whole.
Savings-investment linkage –
Providing the linkage between savings and investment, stock exchanges help in mobilizing savings and channelizing them into the corporate sector as securities.
Furthermore, the prevailing market price of the securities is being determined by transactions made in the secondary market. New issues of outstanding securities to be sold in the primary market are based on the prices and yields in the secondary market. Hence, the capital costs of the corporations are determined by investor expectations and perceptions that are reflected in market price prevailing in the secondary market.
In addition to that, nonpublic IPOs may also be priced based on the prices and values of comparable stocks or bonds in the public secondary market.