1.3 Primary and Secondary Markets

We divide the capital markets into two notional submarkets: the primary and secondary markets. The primary marketThe market where securities are traded for the first time and where initial offerings to the public are made. is the market for the first issuance of a security. The secondary marketThe market for trading securities after they have been issued. trades securities after their initial issuance. Secondary markets are much larger than primary markets.

Primary markets are for securities offered for sale for the first time. A primary market transaction is one in which there is an initial sale of a security by a firm or government and the issuer receives the funds raised by the sale. The primary market is intermediated by investment banksA financial intermediary that purchases securities from corporate and government issuers and resells them to the general public in the primary market.. The banks (alone or in groups) buy the new securities from the issuer and sell them to individual investors and funds. The banks profit from the spread between the buy and sell prices. Secondary markets are for securities traded after their initial sale. For example, in September of 2019, Peloton Interactive Inc., the U.S. fitness equipment company, sold over $1.16 billion in stock in an initial public offering (IPO)Where a firm first offers shares to the public and the firm becomes a public company.. This was a primary market transaction because Peloton received the proceeds of the sale. A secondary market transaction occurs if those same shares are resold today because Peloton would not receive any of the funds from this sale.

To understand the size of the primary markets, Figure 1.9 shows the dollar value of issuance of new securities in the U.S. capital markets.

First note the scale on the y-axis. In 2022 (the bar on the far right), almost $9 trillion of capital was raised in the U.S. capital markets. To benchmark that value, consider that the GDP of the United States in 2022 was about $24.5 trillion. By far the largest issuer of securities was governments (Federal agencies, states, and municipalities). Note that corporations typically constitute about 20% of the capital markets and that equity is a substantially smaller source of capital than debt.

Next, let’s look at equity markets in more detail. Figure 1.10 shows common equity issuance by corporations.

The first thing to notice is how small equity issuance is relative to total issuance in U.S. capital markets. In 2022, there was only $88 billion of common equity issued but total issuance was over U.S. $8.9 trillion. Figure 1.10 divides common equity issuance into two parts: (1) IPOs and (2) follow-ons. Follow-ons are all subsequent issuances by companies after their IPO. Note how small IPOs are as a proportion of new equity issuances. To give you a sense of how infrequent they are, in 2022 there were only eighty-six IPOs in total.

Secondary markets are the markets for trading securities after they have been issued. The seller of the security in the secondary market is never the issuer, although many companies will buy back their own shares—share buybacks are an alternative to dividends and will be explained in more detail later in this book. To understand the scale of the secondary market and the relative sizes of the various submarkets, Figure 1.11 shows average daily trading volume (in dollars) for government bonds, mortgage- (and asset-) backed securities, corporate bonds, and equities.

You may be surprised to learn that trading in government bonds accounts for a large portion of secondary market activity. This trading in government bonds is more than the value of trading in corporate bonds, which is minuscule, and even more than the value of trading of equities. Third largest is trading in MBS&ABS (mortgage- and asset-backed securities). The results are somewhat deceptive, because bond prices are much higher than stock prices. Many bonds have face values of US$1 million. Thus, while the value of trading in bonds is greater, the number of stock shares that trade is much larger than the number of bonds that trade.

Another important fact to understand is that, in stocks, the U.S. markets represent a very large fraction of the global market for equities. Figure 1.12 shows the breakdown of global equity market capitalization by country. Equity market capitalization is simply the value of shares listed in the market (price times quantity). The total value of all shares listed globally at the end of 2022 was about US$101 trillion.

U.S. stock markets account for 40% of the value of all shares listed in all markets around the globe. The value is far greater than Europe and China, which both  have economies about the same size as that of the United States. 

Another category of secondary markets is the derivative markets. Derivatives are securities like futures, options, and swaps whose value is derived from the value of some other underlying security. Derivative markets are very large. Figure 1.13 shows the size of global derivatives markets. Size in Figure 1.13 is measured by something called the “notional principal value outstanding,” which is similar to market capitalization. The total global notional principal value outstanding of derivative contracts at the end of 2022 was about US$700 trillion. This dwarfs the value of global equity markets. 

The primary markets are the source of capital for businesses, so it is easy to understand their importance for a growing and vibrant economy. The role of secondary markets is harder to understand. Some criticize them as being glorified casinos. While prices certainly fluctuate in secondary markets, their primary role is to provide the means for investors to tailor their investment horizons (i.e., to sell their shares according to their personal financial needs). Without a secondary market investors would have to wait for a liquidation, takeover, dividend, or repurchase in order to get some or all of their money back. Those events don’t often coincide with investors’ need for cash, so an active secondary market is a critical feature of the stock markets.

Given that secondary markets perform an important economic function, what are the characteristics of good markets? Among the most important are accurate pricing of stocks and liquidityA securities market with a high volume of trading activity in which it is easy to buy and sell. Liquid markets also have depth, which means large quantities can be traded quickly without impacting the price adversely..

One of the most important roles of secondary markets is establishing security prices. Setting accurate prices is not trivial. Consider the case in which something is bought secondhand. Both buyer and seller want the exchange price to be fair. The problem is how to set a fair price when neither the buyer nor the seller knows the price other people have set for the item. Let us consider two secondhand items: a car and a desk.

Suppose you want to buy a 2019 BMW 328 from your neighbor. You would probably begin establishing the value of the car by consulting Autotrader or Kelly Blue Book. The first is an online marketplace for used cars and the second estimates average prices by attending large car auctions. You and your neighbor then adjust the actual price up or down, depending on the condition of the car.

Now suppose that you want to buy your neighbor's antique Louis XV writing desk. The market for the desk is much thinner, meaning not many are bought or sold. Therefore, you will have a more difficult time establishing its true value. No central market exists in which similar desks are frequently traded and there is no value guide to consult. The result is that neither you nor your neighbor are sure what the true value of the desk should be. If you think it is worth less than what your neighbor thinks it is worth, then no transaction will occur.

What are the differences between the markets for used cars and custom furniture?