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Secondary Markets

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Any trade of a security after its primary offering is called a secondary market transaction. When an investor buys 100 shares of IBM on the New York Stock Exchange, the proceeds of the sale do not go to IBM. They go to the investor who sold the shares.

From an investor's perspective, the function of a secondary market is to provide liquidity of their assets at fair prices. An asset is an item of value owned by an individual or corporation. Liquidity is the speed at which an asset such as stock, bonds, or real estate, can be converted into cash.

Liquidity is achieved if investors can trade large amounts of securities without affecting prices. Prices are said to be fair if they reflect the underlying value of the security correctly.

There are three liquidity-related characteristics of a secondary market that investors find desirable: depth, breadth, and resiliency. First, a secondary market is said to have depth if there are orders both above and below the price at which it is currently trading. When a security trades in a deep market, temporary imbalances of purchase or sale orders that would otherwise create substantial price changes are offset with corresponding orders. Second, a secondary market is said to have breadth if its orders give its market depth in a significant volume. The broader the market for a stock, the greater the potential for stabilization of temporary price changes that may arise from order imbalances. Third, a market is resilient if orders promptly respond to price changes.

There are four types of secondary markets: direct search, brokered, dealer, and auction. Each type differs according to the amount of price information investors have access to.

Direct Search

The secondary market that offers you the least amount of price information is that in which the buyers and sellers have to search each other out directly. For this reason, this is called a direct search secondary market. Because the full cost of locating and bargaining with a willing and capable trading partner is paid by an individual investor, there is only a small incentive to conduct a thorough search among all possible partners in the market for the best possible price. By the time a trade is agreed upon by the two investors, at least one of the participants could have gotten a better price if they were in contact with some other participant they never found. Stocks that trade in direct search markets are the ones people buy and sell so infrequently that a third party, such as a broker or a dealer, has no incentive to provide any kind of service to facilitate this trading. The common stock of smaller companies, especially small banks, trades in direct search markets. Buyers and sellers of those issues must rely on word-of-mouth communication to attract compatible trading partners. The relatively small number of trades makes it difficult to find an economical way of broadcasting quotations or transaction prices. Trades can occur at the same time at quite different prices, and these transactions are usually far from the best possible price.

Brokered

When the trading of a specific stock becomes sufficiently heavy, brokers begin to offer specialized search services to market participants. For a fee, called a brokerage commission, brokers help find compatible trading partners and negotiate acceptable transaction prices for their clients.

Brokers are most likely to be involved when a lot of investors are in the market because it is more profitable for them. If a broker can fill two customer's orders at a cost less than twice the cost of the direct search that would otherwise be conducted by each of those customers, then brokers will offer their services. This is important because they can profitably acquire the business of both investors by charging a commission somewhat less than the cost of a direct search.

Since brokers are frequently in contact with many market participants on a continuing basis, they are likely to know what a "fair" price is for a transaction. Stock brokers arrange transactions closer to the best available price than is possible in a direct search market. Their extensive contacts provide them with a pool of price information that individual investors could not economically duplicate because of cost. By charging a commission less than the cost of direct search, they give investors an incentive to use the information the broker has.

Even though a brokered market is better than a direct search market, a brokered market cannot guarantee that orders will be executed promptly. Not knowing about the speed of execution creates price risk. While a broker is searching for a trading partner for a client, prices may change and the client may suffer a loss.

Dealer

As the trading of a stock becomes even more active, some market participants may begin to maintain bid and offer quotations of their own. These traders become dealers. They buy and sell their own inventory at their own quoted prices. Dealer markets eliminate the need for time consuming searches for trading partners, because investors know they can buy or sell immediately at the quotes given by a dealer.

Dealers often sell their stocks at a price greater than the bid price they pay. The difference between the two, called the bid-ask spread, compensates them for providing the liquidity of an immediately available market to occasional participants. This also pays for the risk that dealers incur when they position a security in their inventory. The bid price is the highest price that someone is willing to pay to buy shares of stock. This also means that this is the highest price you can expect to get for your shares of stock when selling them. It is always lower than the ask price. The ask price is the lowest price you can pay for a stock. This is because it is the lowest price any seller is offering their shares for.

Although dealer markets provide investors with the opportunity for an immediate execution of their orders, and although dealer markets can usually be searched more rapidly and cheaply than a direct search or brokered markets, they do have several disadvantages. No one can guarantee that the quotation of a particular dealer could be improved upon by contacting another dealer. This being the case, investors operating in dealer markets have to bear some cost of searching for the best price.

Auction

Auction markets provide centralized procedures for the exposure of purchase and sale orders to all market participants simultaneously. In other words, an auction market is a place where anyone who wants to buy and sell can go to. This is important because auction markets virtually eliminate the expense of locating compatible partners and bargaining for a favorable price. The communication of price information in an auction market may be oral if all participants are physically located in the same place, or the information can be transmitted electronically.