Market Structure and Offerings

The four markets

The primary market is where securities are issued. The proceeds go to the issuer, and the transaction is governed by the Securities Act of 1933.

The secondary market is where existing securities trade between investors. The proceeds go to the selling investor. This is where almost all trading volume happens.

The third market is exchange-listed securities traded over the counter, away from the listing exchange.

The fourth market is institution-to-institution trading without a broker-dealer intermediary, generally through electronic networks.

The third and fourth are worth memorizing as a pair because the names give no clue: third means listed securities traded off-exchange, fourth means institutions trading directly with each other.

Exchanges and the over-the-counter market

An exchange is an auction market: orders meet in one venue and the price is set where the highest bid meets the lowest offer. The New York Stock Exchange combines electronic trading with a physical floor, where a designated market maker has an obligation to maintain a fair and orderly market in assigned securities.

The over-the-counter market is a dealer or negotiated market. There is no central floor; dealers quote a bid and an offer and trade for their own account. Nasdaq is an electronic market with competing market makers in each security. Securities not listed on an exchange trade through quotation systems operated by OTC Markets Group.

An alternative trading system matches orders without being registered as an exchange. Electronic communication networks display orders and match them electronically; dark pools do not display orders before execution, which lets institutions work large orders without signalling size.

The practical difference for a customer: on an exchange, the firm usually acts as agent and charges a commission. In the OTC market, a firm dealing from inventory acts as principal and earns a markup or markdown inside the price. The confirmation must state which.

Offerings

An initial public offering is a company's first sale of securities to the public. A follow-on offering is a later sale of newly issued securities by an already-public company. A secondary offering is a sale by existing shareholders rather than by the issuer, so the proceeds go to those shareholders — a distinction the exam tests, since the names sound interchangeable and are not.

A public offering is registered with the SEC and sold to anyone. A private offering relies on an exemption, is sold to a limited set of investors, and produces restricted securities that cannot be freely resold.

The participants: the issuer raises the money; an investment bank advises and underwrites; a syndicate of underwriters shares the distribution and the risk; a selling group helps distribute without taking risk; and for a municipal issue, a municipal advisor may advise the issuer.

The two principal methods of distribution:

Firm commitment — the underwriters buy the entire issue from the issuer and resell it, bearing the risk of anything unsold. The issuer's proceeds are certain.

Best efforts — the underwriter acts as agent and returns unsold securities to the issuer, which bears the risk. Variants include all-or-none, where the offering is cancelled unless the whole issue sells, and mini-max, which sets a minimum and a maximum.

A shelf registration under SEC Rule 415 registers securities for an offering to be made on a delayed or continuous basis, so the issuer can bring them to market when conditions suit without filing again.

Offering documents and the registration process

A registered offering is sold with a prospectus, which is Part I of the registration statement filed with the SEC. It describes the business, the financial statements, the use of proceeds, the risk factors and the securities offered.

The process has three stages. Before filing, nothing may be offered or sold. Between filing and effectiveness — the cooling-off period — the preliminary prospectus or red herring may be distributed and indications of interest may be taken, but no sales, no confirmations and no money. After effectiveness, sales may be made, with the final prospectus accompanying or preceding the confirmation.

A tombstone advertisement may be published during the cooling-off period. It names the issuer, the amount and type of security, the underwriters and where a prospectus may be obtained, and states that it is not an offer to sell.

Municipal issues use an official statement rather than a prospectus, because municipal securities are exempt from Securities Act registration. Municipal fund securities — 529 plans and ABLE accounts — use a program disclosure document.

Blue-sky laws are the state registration requirements that sit alongside the federal ones, and a federal covered security is one for which federal law pre-empts state registration.