Primary and secondary markets, and how trading is organized

How do issuers raise money in the primary market?

By selling new securities to investors, either to the public or to a small group of qualified investors. In the primary market the issuer receives the cash.

Primary marketthe issuer sells and receives the cash

• Public offering
  • IPO Memorize first sale of shares to the public
  • Seasoned offering Memorize more shares from a listed issuer
  • Underwritten Memorize bank guarantees the sale and takes unsold shares
  • Best effort Memorize bank only acts as broker
  • Shelf registration Use it register once, sell over time
• Private placement Use it qualified investors, cheaper, less liquid, higher required return
• Other routes
  • Rights offering Use it existing holders get the right to buy at a set price
  • Dividend reinvestment plan Know the idea dividends buy new shares
  • Government auction Know the idea bills, notes, bonds

An initial public offering (IPO) is the first public sale of a company’s shares. A seasoned offering sells additional shares of an already-listed issuer. Investment banks run both, using book building : they collect indications of interest from investors to build a book of orders at a price.

How the bank commits to the sale is a favorite exam point.

• In an underwritten offering the bank guarantees the sale at the offering price. If the issue is undersubscribed, the bank buys the rest. This is the most common type.
• In a best effort offering the bank acts only as a broker and promises to try. If demand is short, the issuer sells less.

Underwriters have a conflict of interest. As the issuer’s agent they should get the highest price, but as underwriters they bear the risk of unsold shares, so they prefer a lower price that is easy to sell and lets them allocate valuable shares to favored clients. That helps explain why IPO shares so often rise on the first day.

A shelf registration lets an issuer register once and then sell shares over time as it needs funds. A private placement sells directly to qualified investors with less disclosure. It is quicker and cheaper, but buyers cannot resell easily, so they demand a higher return. A rights offering gives existing holders the right to buy new shares at a set price in proportion to their holdings, so they can keep their share of the company. Dividend reinvestment plans and government auctions are other routes.

Go deeper Why underwriters underprice IPOs

A low offering price makes the issue easy to sell and cuts the underwriter’s chance of buying unsold shares. It also lets the bank hand cheap shares to valued clients. The cost falls on the issuer’s existing owners, who sold at less than the shares were worth. Later in the course you will meet this as the IPO anomaly in Market Efficiency.

Go deeper Accelerated book builds and dark pools in one paragraph each

An accelerated book build compresses the book-building process into one or two days, usually at a discount, so an issuer can raise money fast. A crossing network or dark pool matches trades away from public view. Large investors like it because their order cannot move the price before it trades, but the fill is uncertain because a match must be found.

Why does the secondary market matter to issuers?

Investors pay more for securities they can sell easily, and a higher price means a lower cost of capital for the issuer. The company never receives the money from secondary trades, but it benefits from the liquidity.

A liquid secondary market lets investors trade with low costs and small price concessions. Take a 10-year bond. If it can be sold in minutes, it might yield 4.6%. An otherwise identical private bond that cannot be traded might need to yield 5.3%. The 0.7 percentage point difference is the extra return investors require for giving up liquidity, and it is the issuer who pays.

Exam tip When a question asks how the secondary market helps issuers, the answer is the cost of capital, never trading income.

How are secondary markets organized?

By who supplies the other side of the trade. A trading session can be a call or continuous, and the execution mechanism can be quote-driven, order-driven or brokered.

Secondary market structureswho supplies the other side

• Quote-driven Memorize dealers quote, customers trade at their prices
• Order-driven Memorize rules match orders
  • Call market one price, uniform rule
  • Continuous market standing order price, discriminatory rule
  • Crossing network price taken from another market, derivative rule
• Brokered Memorize broker finds a partner

	Quote-driven (dealer, over-the-counter or OTC)	Order-driven	Brokered
Who sets prices	Dealers’ quotes	Rules matching buyers’ and sellers’ orders	Negotiation via a broker
Typical use	Bonds, currencies, many other contracts	Most stock exchanges, electronic venues	Real estate, large blocks, unusual assets, art
Liquidity from	Dealer inventory	The limit order book	The broker’s network

In a quote-driven market , customers trade at the prices dealers quote. Most bonds, currencies and spot commodities trade this way. These are also called over-the-counter markets. In order-driven markets , rules arrange trades from submitted orders. Nearly all exchanges and automated systems work this way. A brokered market suits assets that are unique, rare to trade and costly for a dealer to hold in inventory, so a broker searches a network for a partner.

Sessions come in two types. In a call market , orders are gathered and traded together at one time, often at the open. Everyone is present, so liquidity is high, but there is none between calls. In a continuous trading market , trades happen whenever two orders match. Many continuous markets open and close with a call.

Go deeper A worked call auction with one price

Buy orders: 500 at 25.10, 800 at 25.00, 700 at 24.90. Sell orders: 600 at 24.80, 500 at 24.90, 900 at 25.00. At each candidate price, volume is the smaller of the quantity buyers will take and sellers will give. At 24.80 the volume is 600, at 24.90 it is 1,100, at 25.00 it is 1,300, and at 25.10 it is 500. The auction picks the price that maximizes volume, 25.00, and every trade is done there.

How do order-driven markets match and price orders?

Two sets of rules decide it. Matching rules rank the orders, and pricing rules set the price.

The order precedence hierarchy ranks orders at three levels: price first (the highest bid and lowest offer go first), then display (displayed quantity ahead of hidden quantity at the same price), then time (the earlier order first). These rules reward traders for improving the price, showing their orders and arriving early.

$$\bar{P} = \frac{\sum_i q_i P_i}{\sum_i q_i}$$

Three trade pricing rules exist.

• The uniform pricing rule gives all trades one price, chosen to maximize volume. Call markets use it.
• The discriminatory pricing rule prices each trade at the standing order’s limit price, so a large incoming order walks up the book, as above. Continuous markets use it.
• The derivative pricing rule takes the price from another market, often the midpoint of the primary exchange’s quote. crossing networks use it, so the price does not depend on orders in the network.

Markets also differ in pre-trade and post-trade transparency . Pre-trade transparency means quotes and orders are published in real time, and post-trade transparency means trade prices and sizes are published soon after. Buy-side traders prefer more transparency because it helps them measure costs. Dealers prefer less, because their trading gives them an information advantage, and spreads tend to be wider in opaque markets.