How the Markets Are Structured

Every trade on the exam happens in one of four markets. The exam hands you a transaction and asks which market it belongs to. Learn the deciding question for each one, and these items turn into easy points.

The primary market: the issuer gets the money

The primary market is where an issuer sells new securities to investors for the first time. The issuer receives the proceeds. That last sentence is the whole test.

Say a company sells 10 million new shares at $18 in its initial public offering (IPO). The company collects about $180 million, less the underwriters' fees. Everyone who bought those shares bought in the primary market.

A company that has been public for years can also create and sell brand new shares to raise more cash. That sale is still a primary market transaction, because the issuer made the shares and took the money. New bond issues work the same way.

The exam likes to drop the word "secondary" into an offering's name to see if you flinch. Ignore the label and ask who received the proceeds. If the issuer received them, you are in the primary market.

The secondary market: investors trade with each other

The secondary market is where investors buy and sell securities that already exist. The issuer takes no part in the trade and gets none of the money. The selling investor does.

Buy 100 shares of that IPO company next week at $21, and your $2,100 goes to the investor who sold, less any commission. Nothing reaches the company.

The secondary market is what gives you liquidity, meaning you can sell what you own at a fair price without a long wait. The exam splits the secondary market into three venues, and it uses all three names.

• Physical: an exchange with a real trading floor, like the New York Stock Exchange. It runs as an auction market. Buyers post bids, sellers post offers, and a trade happens when the highest bid meets the lowest offer.
• Electronic: a market with no floor at all, like the Nasdaq Stock Market. Nasdaq is a dealer market. Several market makers compete in the same stock. Each one quotes a buy price and a sell price and trades from its own inventory.
• Over-the-counter (OTC): a decentralized network of dealers with no central marketplace. Each price is negotiated between the two parties rather than auctioned. Most bonds trade OTC, and so do stocks that are too small for an exchange listing.

The third market: listed stock, traded off the exchange

The third market is trading in an exchange-listed security that happens in the OTC market instead of on its exchange. A broker-dealer is still in the middle.

Picture a pension fund that wants to sell 400,000 shares of an NYSE-listed stock. Sending that block to the exchange would push the price down before the fund finished selling. So the fund sells through a broker-dealer's OTC desk at a negotiated price, which is a third market trade. The trade still gets reported.

Two conditions have to hold. The security is listed on an exchange, and the trade happens away from that exchange. A stock that has no listing at all is just ordinary OTC trading, not the third market.

The fourth market: institutions, direct

The fourth market is direct trading between institutions with no broker-dealer in the middle. Think of mutual funds, pension funds, and insurance companies dealing straight with each other.

These trades run through an electronic communication network (ECN), a computer system that matches institutional buy and sell orders. Cutting out the broker-dealer saves the commission and keeps a big order out of public view until it is done.

How this gets tested

Nearly every item on this topic describes a transaction and asks for the market. Two questions sort them all out.

First, did the issuer receive the money? Yes means the primary market. No means one of the other three.

Second, who stood in the middle, and where did the trade happen? On an exchange means plain secondary market. A broker-dealer trading a listed stock off-exchange means third market. No broker-dealer at all, one institution facing another, means fourth market.

Run the five transactions you will keep seeing through those two questions:

• A company sells new shares in an IPO, or brings a new bond issue: primary market.
• You buy a listed stock on the NYSE or on Nasdaq from another investor: secondary market.
• A dealer sells you a corporate bond or an unlisted stock from inventory: secondary market, OTC.
• A broker-dealer executes a trade in an NYSE-listed stock away from the NYSE: third market.
• Two pension funds trade a block with each other through an ECN: fourth market.

Third and fourth are the pair the exam swaps most often. Both involve institutions trading away from an exchange. The broker-dealer is the difference: present in the third market, absent in the fourth.