Market Structure and Participants

Primary, secondary, third and fourth

The primary market is where securities are issued and the proceeds go to the issuer. Module 8 covers it in full.

The secondary market is where existing securities trade between investors, and the proceeds go to the selling investor rather than to the issuer. Everything in this module is secondary market.

The third market is exchange-listed securities traded over the counter, away from the listing exchange — historically institutions trading NYSE-listed stock through OTC market makers.

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

The distinction between the third and fourth markets is a favourite because the names give no clue. Third means listed securities traded off-exchange; fourth means institutions trading directly with each other.

Exchanges and the OTC market

An exchange is an auction market. Orders meet in a central venue, and the price is set by the highest bid meeting the lowest offer. The New York Stock Exchange runs a hybrid of electronic trading and a physical floor, where a Designated Market Maker has an affirmative obligation to maintain a fair and orderly market in its assigned securities — quoting on both sides, and buying and selling against the trend when there is a temporary imbalance. Floor brokers execute orders for customers.

The over-the-counter market is a dealer market, sometimes called a negotiated market. There is no central floor; dealers hold themselves out as willing to buy at their bid and sell at their offer, and the trade happens between the customer's firm and a dealer. Nasdaq is an electronic market with multiple competing market makers in each security. Below it, OTC equity securities that are not listed on an exchange trade through quotation systems operated by OTC Markets Group, with tiers reflecting how much current information the issuer provides.

A market maker is a dealer that quotes a two-sided market and stands ready to trade for its own account. Its bid is what it will pay and its offer is what it will sell at; the difference is the spread, which is its compensation. The inside market is the highest bid and the lowest offer across all market makers.

A critical distinction for later lessons: on an exchange, a firm executing a customer order usually acts as agent and charges a commission. In the OTC market, a firm dealing from its own inventory acts as principal and earns a markup or markdown built into the price. Lesson 7.3 develops the consequences.

Alternative trading systems, ECNs and dark pools

An alternative trading system is a venue that matches orders but is not registered as an exchange. Regulation ATS sets the conditions: an ATS must register as a broker-dealer, file a Form ATS notice, and comply with additional requirements — fair access, order display and capacity standards — once its volume in a security passes specified thresholds.

An electronic communications network is an ATS that displays orders and matches them electronically, giving subscribers direct access to each other's orders. ECNs are the machinery of the fourth market and they operate outside normal exchange hours as well as during them.

A dark pool is an ATS that does not display its orders before execution. Institutions use them to work large orders without signalling size to the market, which would move the price against them. Trades are reported after execution, so the transaction appears on the tape but the intention did not appear on any book.

The policy trade-off is worth understanding rather than memorizing: displayed orders create the price discovery everyone relies on, and undisplayed orders take advantage of that price discovery without contributing to it. That tension is why fair access and volume thresholds exist in Regulation ATS.

Brokers, dealers and the firms behind them

A broker acts as an agent, executing an order for a customer's account, and is compensated by commission. A dealer acts as a principal, buying from or selling to the customer out of its own account, and is compensated by a markup or markdown. Most firms are broker-dealers and act in either capacity depending on the trade — but never in both capacities on the same trade, which is why the confirmation must state the capacity.

An introducing firm has customer relationships but does not hold customer assets; it introduces its business on a fully disclosed basis to a clearing firm. The clearing firm carries the accounts, holds the securities and cash, produces confirmations and statements, and handles settlement. The customer's assets sit at the clearing firm, which is the firm whose SIPC membership is relevant if things go wrong.

A prime broker arrangement lets an institutional customer execute with many firms while settling and holding everything at one designated prime broker, which consolidates margin, financing and reporting.

Other participants the outline names: an investment adviser manages assets for a fee; a municipal advisor advises municipal entities on issuance and owes them a fiduciary duty; issuers create securities and underwriters distribute them; and traders act for their firm's own account.

The plumbing

A transfer agent, appointed by the issuer, maintains the record of registered owners, cancels and issues certificates, processes transfers, and distributes dividends and interest. It is also who a customer's firm deals with over a lost certificate or a name change.

A registrar audits the transfer agent's work, ensuring the number of shares outstanding never exceeds the number authorized. The two functions are separated for exactly that reason.

A custodian holds securities for safekeeping on behalf of an owner — a fund, a trust, a retirement plan.

The Depository Trust and Clearing Corporation is the central infrastructure of the US securities market. Its Depository Trust Company subsidiary immobilizes securities in book-entry form so that a change of ownership is a bookkeeping entry rather than a physical movement. Its National Securities Clearing Corporation subsidiary nets and settles trades between firms, so that thousands of transactions between two firms become one net obligation. Without netting, the settlement system would not function at current volumes.

The Options Clearing Corporation performs the analogous function for listed options, as lesson 6.1 covered: it issues, guarantees and settles every listed option contract.