Exploring Secondary Markets | CFA Level I Equity Investments

In this lesson, we’ll delve into the world of secondary markets and their structures, following our discussion on primary markets.

Secondary Markets: Liquidity and Price Information

Secondary markets are vital as they provide liquidity and price information. A liquid market allows securities to be sold quickly without causing a significant discount from the current price. The liquidity of secondary markets influences primary markets, as buyers value liquidity and are willing to pay more for easily sellable securities. This, in turn, enables issuers to raise capital at a lower cost.

Market Structures: When and How Securities are Traded

Secondary market structures can be classified based on when and how securities are traded:

When: Call Markets vs. Continuous Trading Markets

• Call Markets: Stocks are traded only at specific times. All interested buyers and sellers gather at a specific time and place to declare their bids and asks, with one negotiated price set to clear the market for the stock. Call markets can be very liquid during sessions but are illiquid between sessions.
• Continuous Trading Markets: Trades can be arranged and executed at any time the market is open. Many continuous trading markets begin with a call market auction, followed by continuous trading sessions.

How: Quote-driven, Order-driven, and Brokered Markets

• Quote-driven Markets: Investors trade with dealers or market makers who post bid and ask prices. Dealers maintain an inventory of securities. These markets are also known as over-the-counter (OTC) markets.
• Order-driven Markets: Rules are used to match buyers and sellers. Stocks are mostly traded in exchanges or automated trading systems, which are mainly order-driven markets.
• Brokered Markets: Investors use brokers to locate a counterparty for a trade. This service is typically for unique or illiquid assets like large blocks of stock, real estate, and artwork.

Order matching rules determine which orders get priority and how they are matched. The main criteria are price priority, non-hidden orders, and earliest arriving orders.

Trade Pricing Rules

Trade pricing rules include:

• Discriminatory Pricing Rule: Used in continuous trading markets. The limit price of the order that arrived first determines the trade price.
• Uniform Pricing Rule: Used in call markets. All orders trade at the same price, resulting in the highest volume of trading.
• Derivative Pricing Rule: Used in crossing networks. The price is often the midpoint between the best bid and ask quotes published by the exchange.

Market Transparency

Markets differ in the type and quantity of data they disseminate to the public:

• Pre-trade Transparent Markets: Publish real-time data about quotes and orders.
• Post-trade Transparent Markets: Publish trade prices and sizes only after the trades occur.

Buy-side Traders vs. Dealers

Buy-side traders and dealers have different preferences when it comes to market transparency:

• Buy-side Traders: Prefer pre-trade transparent markets, as transparency allows for a better understanding of security values and trading costs.
• Dealers: Prefer post-trade transparent markets, which are more opaque, as it gives them an informational advantage over traders who trade less frequently. Transactions costs and bid-ask spreads are larger in opaque markets.

Conclusion

We’ve explored secondary markets, market structures, and trade pricing rules. We’ve also discussed market transparency and how it affects different types of traders. In our next lesson, we’ll learn about the characteristics of a well-functioning financial system.