Primary markets, secondary markets and how trades are arranged

Primary markets: public offerings

When issuers first sell securities to investors, the trade is in the primary market. An initial public offering (IPO), or placing, is the first public sale; selling more units of an existing (seasoned) security is a seasoned (follow-on) offering. Older texts call a follow-on by the issuer a 'secondary offering'; newer usage keeps primary follow-on for new, dilutive shares and secondary follow-on for existing shares sold by holders (non-dilutive, no proceeds to the issuer). Read the word in context. Later trading among investors happens in secondary markets.

Companies usually hire an investment bank to line up buyers, a process called book building (the London book builder is the book runner). Before the offer, the issuer discloses its business, risks and use of funds in detail. In Europe an accelerated book build done in a day or two, usually at a discount, is used when time matters. An IPO may include new shares from the company and existing shares sold by founders and early investors who want to cash out.

In an underwritten offering, the most common type, the bank guarantees the sale at the negotiated offering price and buys anything unsold. For IPOs it typically also makes a market for about a month to support liquidity and the price. Large issues use a syndicate, and fees are around 7%. In a best efforts offering the bank acts only as broker, so an undersubscribed issue simply sells less.

A price set too high leaves the offer undersubscribed; too low, oversubscribed, and shares are allocated to favoured clients or pro rata (Standard III(B) calls for a disclosed, fair allocation policy). Underwriters have a conflict of interest: as the issuer's agent they should maximise proceeds, but a low price lets them reward clients and avoid buying and supporting overpriced shares. So IPO prices tend to be low and often jump on the first day. First-time issuers accept this because an undersubscribed IPO signals bad news and makes later fundraising harder. The problem is smaller for seasoned offerings, where a market price already exists.

Other primary-market routes, and why secondary markets matter

A private placement sells securities directly to a small group of qualified investors with far less disclosure. It can be cheaper, but buyers demand higher returns (lower prices) because they cannot resell in an organised secondary market.

A shelf registration completes all disclosure up front but sells shares into the secondary market bit by bit when capital is needed, giving timing flexibility and less price pressure than one big offering. A dividend reinvestment plan (DRP/DRIP) issues new shares to holders who reinvest dividends, sometimes at a small discount. A rights offering gives existing holders rights, in proportion to their holdings, to buy new shares below market price; holders must exercise or sell the rights to avoid dilution, so they tend to dislike them. Analysts value the rights as short-term warrants.

Strong national governments usually sell bills, notes and bonds in public auctions (or directly to dealers); smaller or weaker governments often use investment banks, though many are required by law to auction.

Secondary markets support primary markets. In a liquid market investors can sell quickly with small price concessions, so they pay more for securities they can resell. Higher prices mean a lower cost of capital for issuers.

Trading sessions: call markets vs continuous markets

Trading is a two-sided search, and market structures exist to make it cheaper. In a call market, trades can be arranged only when the market is called at a set time; in a continuous market, any time it is open.

Call markets concentrate all orders at one moment, so they can be very liquid then, but they are completely illiquid between calls. Continuous markets let a willing buyer and seller trade at any time, but only if both are present at the same time.

Most call markets run a single-price auction: they build the buy and sell order books (effectively demand and supply schedules) and choose the one price that maximises the volume traded. Many continuous markets open with a call after a pre-opening period, and some close with one, where traders use market- or limit-on-close orders.

Execution mechanisms: quote-driven, order-driven and brokered

In quote-driven (price-driven, dealer, OTC) markets, customers trade at prices quoted by dealers. Most trading other than in stocks works this way: almost all bonds and currencies and most spot commodities. Trades now run over electronic networks, phone or messaging.

In order-driven markets, rules match buy and sell orders submitted by customers or dealers. Almost all exchanges and every automated system are order-driven. Because traders often deal with strangers, these markets need procedures that make everyone settle.

In brokered markets, brokers find counterparties for unique, rarely traded assets that dealers will not hold in inventory and that would draw too few orders for an order-driven market: large blocks of shares, real estate, art, intellectual property, whole companies, licences. Good brokers know everyone who might trade.

Many systems combine structures. Transparency matters too: a market is pre-trade transparent if it publishes quotes and orders in real time and post-trade transparent if it publishes trade prices and sizes soon after. Buy-side traders like transparency; dealers prefer opaque markets, where spreads and costs tend to be higher.

Order-driven rules: matching and pricing

Order matching rules rank orders by an order precedence hierarchy: first price priority (highest buy, lowest sell), then display precedence (displayed size before hidden size at the same price), then time precedence (earliest first). This rewards improving the price, displaying size and arriving early, which all add liquidity. The top buy is matched with the top sell for the smaller quantity, and so on until no more trades are possible.

Trade pricing rules set the price. Call markets use the uniform pricing rule: everyone trades at the single volume-maximising price. Continuous markets use the discriminatory pricing rule: each trade executes at the limit price of the standing order. A large arriving order walks through the book, paying each standing order's price in turn.

Crossing networks use the derivative pricing rule: they match buyers and sellers at a price taken from another market, typically the midpoint of the main exchange's best bid and offer, independent of the orders submitted to the network.