What would happen if we didnt have secondary mkts

Written by Sunil K Parameswaran | Updated: Oct 5 2012, 07:02am hrs
All of us may not have participated in a primary market transaction, but odds are that most of us who are involved with the world of finance and financial instruments have participated in a secondary market transaction.

The primary market is where corporations issue shares and bonds to investors. It is also the arena where governments issue bonds to the public.

If a company is issuing equity shares for the very first time, it is termed as an initial public offering (IPO). Subsequent offerings are termed as follow-on public offerings (FPOs). Once the initial transaction between the issuer and the investor is consummated, subsequent transactions between two investors are termed as secondary market transactions. Thus, primary markets facilitate the raising of capital by companies and governments. Secondary markets serve to facilitate transfer of ownership of securities from one investor to another.

What would happen if we did not have a secondary market Let us consider bonds first. Most of them have a finite lifespan. If we were to invest in a bond with 20 years to maturity, we would have no option but to hold it for 20 years. For equity shares, the issue is more serious as these do not have a maturity date. The only option for an investor would be to hand it down from generation to generation, and it could obviously never leave the family. This is obviously not a very satisfactory arrangement.

One of the key reasons as to why we invest in financial securities is because these instruments can be easily converted into cash at any point in time. Securities which can be easily converted into cash are termed as liquid securities.

There is another reason why most investors require access to secondary markets. All of us are instinctively risk averse and believe in the principle of diversification. For instance, if I were to bestow you with R10 million in cash, would you invest the entire amount in Infosys shares Quite obviously you would not. First, you would not invest the entire amount in the stock market. You may invest a part in stocks, a portion in bonds, and possibly even a part of it in real estate or gold.

As far as the equity component is concerned, you would obviously not keep everything in Infosys. In addition to the IT sector, you would also typically invest in other sectors of the economy and, even in IT, you would invest in other companies.

As an individual moves through the life cycle, from the early years of employment, to middle age, to the onset of retirement, his or her risk appetite will change. People who are new to the employment market, and do not have significant responsibilities to shoulder, are typically more risk taking.

As a person approaches middle age and the children are ready to go to college, the tendency is to strike a balance between equity and debt instruments. And, finally, with the onset of retirement, the objective is to typically earn a steady monthly income, and such investors have a considerably reduced appetite for risk or surprises. Quite obviously, as we grow through the life cycle, we need the ability to rebalance or change the composition of our asset portfolio.

A secondary market may be an organised exchange like the BSE and the NSE in India or like the NYSE in the US. Such markets may also be an informal network of brokers and dealers without a formal structure. The latter are termed as OTC or over-the-counter markets, where the term implies that trading in such markets is not on an organised exchange. While equity shares are largely traded on exchanges, a substantial part of bond trading globally is OTC.

The foreign exchange market is also an OTC market. Among derivatives, forward contracts are always traded OTC, while futures contracts are always traded on an exchange. Options, however, are traded both on and off the exchange.

One of the biggest advantages of having an active secondary market is from the standpoint of valuation of an asset. Let us assume that we have 25,000 shares of company XYZ and that a potential counter-party is willing to buy it. The question is what would be a fair price. If we have an active order driven market like the NSE or an active OTC market with market makers providing two-way quotes, then we should be able to zero in on a fair and mutually acceptable price. Otherwise, we would have no option but to requisition the services of a valuation professional, and by the time we end up compensating him for his services, the original counterparties may have little to gain from the deal.

The writer is the author of Fundamentals of Financial Instruments published by Wiley, India