Understanding where and how securities are created and traded is foundational to the Series 7.
Primary market: Where securities are first issued. The company (or government entity) sells newly created securities directly to investors, and the proceeds go to the issuer. An IPO (Initial Public Offering) is a primary market transaction. When Uber went public in 2019 and sold shares to investors for the first time, that was a primary market transaction -- Uber received the money.
Secondary market: Where previously issued securities trade between investors. When you buy Apple stock on NASDAQ today, Apple receives nothing. You are buying from another investor who already owned those shares. The NYSE and NASDAQ are secondary markets. All day-to-day stock trading occurs in the secondary market.
Key distinction: Primary market = issuer gets the money. Secondary market = investors trade among themselves.
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The New York Stock Exchange (NYSE) is an auction market (also called an agency market). Key features:
Real-world example: On a volatile day when no investor wants to buy XYZ stock, the DMM steps in and buys at the prevailing price, preventing a disorderly price collapse.
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NASDAQ is a dealer market (also called a negotiated market). Key features:
Real-world example: For AAPL stock, 10+ competing market makers all post bids and asks simultaneously on NASDAQ. Competition among market makers generally keeps spreads narrow.
Agency vs. Principal trades:
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Over-the-Counter (OTC) markets handle securities not listed on formal exchanges.
OTC Bulletin Board (OTCBB): Electronic quotation system for unlisted securities with some SEC-reporting requirements.
Pink Sheets (OTC Pink): For securities not required to file with the SEC; minimal disclosure requirements; includes many small, speculative, and foreign companies. Named for the pink paper on which quotes were historically printed.
Key risks of OTC/Pink Sheet stocks:
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Electronic Communication Networks (ECNs): Computerized systems that automatically match buy and sell orders without human intervention. ECNs often operate after regular market hours, enabling extended-hours trading.
Alternative Trading Systems (ATS): SEC-regulated platforms (Reg ATS) that match buyers and sellers but are not registered as national securities exchanges. Includes ECNs and dark pools.
Dark pools: Private trading venues where large institutional orders can be executed anonymously without displaying them in the public market. Benefits: reduced market impact for large orders. Concerns: opacity, potential for conflicts of interest, and reduced price discovery for the broader market.
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When a company raises capital for the first time through a public stock offering:
1. Select underwriters: The company hires an investment bank (or syndicate of banks). The lead underwriter is called the book runner.
2. File registration statement (S-1) with the SEC: Includes audited financials, business description, risk factors, and use of proceeds. During the SEC review period, the company may distribute a preliminary prospectus (red herring) to gauge interest. Cannot make sales during this period.
3. Road show: Management and underwriters present to institutional investors and build the order book. Retail investors typically cannot participate.
4. Pricing: Based on the order book, the underwriters and company agree on the offering price. The effective date is when the SEC declares the registration effective.
5. Allotment and distribution: Underwriters allocate shares.
6. Trading begins: Once shares are distributed, secondary market trading begins.
Firm commitment: Underwriter purchases all shares from the issuer and assumes the risk of selling them. Most common IPO structure.
Best efforts: Underwriter tries to sell as many shares as possible but does not guarantee the full amount.
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Quiz Questions:
Q1. An investor buys 1,000 shares of a stock on the NYSE the day after its IPO completed. Which market did this transaction occur in?
A) Primary market, because it was an IPO B) Secondary market, because the investor bought from another investor, not the issuer C) Primary market, because the NYSE is a primary exchange D) OTC market, because IPO shares are not listed for 30 days
Answer: B -- Once IPO shares begin trading on an exchange, all subsequent purchases are secondary market transactions. The company received money only during the initial IPO (primary market). The NYSE is always a secondary market venue. There is no 30-day waiting period for exchange trading (D is wrong).
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Q2. A broker-dealer executes a customer's order by selling shares to the customer from the firm's own inventory. The broker-dealer is acting as a:
A) Agent, earning a commission B) Principal (dealer), earning the bid-ask spread C) Market maker on a national exchange D) Underwriter in a primary offering
Answer: B -- When a broker-dealer trades from its own inventory (buys or sells to a customer using its own holdings), it acts as a principal or dealer. The firm profits from the bid-ask spread, not a commission. When acting as principal, the firm must disclose this to the customer. Acting as agent (A) means the firm facilitates the trade between buyer and seller and earns a commission.
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Q3. Which of the following BEST describes the NYSE Designated Market Maker (DMM) obligation?
A) Post the lowest available ask price for each assigned security B) Maintain fair and orderly markets by providing liquidity, including buying when no buyers exist C) Execute all orders electronically without human intervention D) Match orders only from institutional clients
Answer: B -- DMMs are obligated to maintain fair and orderly markets in their assigned securities. This includes stepping in with their own capital to buy when there are no willing buyers or sell when there are no willing sellers. This affirmative obligation is the key structural feature of the NYSE auction market that distinguishes it from NASDAQ's competing market maker model.
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Q4. During the IPO process, a company distributes a preliminary prospectus to institutional investors before the offering becomes effective. This document is commonly referred to as a:
A) Final prospectus B) Tombstone advertisement C) Red herring D) Offering circular
Answer: C -- The preliminary prospectus is called a "red herring" because it historically bore a red-ink disclaimer stating the information was preliminary and subject to change. It is used during the road show to provide information but does not contain the final offering price. The final (definitive) prospectus is delivered at or before sale. A tombstone (B) is a post-offering advertisement with minimal details.
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Q5. Which of the following BEST describes the primary concern regulators have about dark pools?
A) Dark pools charge excessive commissions compared to traditional exchanges B) Dark pools are only accessible to retail investors, disadvantaging institutions C) Dark pools reduce price transparency because large trades are hidden from the public market D) Dark pools are not subject to any SEC regulation
Answer: C -- The primary regulatory concern about dark pools is reduced price transparency. By hiding large orders from the public market, dark pools can reduce the quality of price discovery for all participants. They are regulated under Reg ATS (D is wrong) and are used primarily by institutional investors, not retail investors (B is wrong). They typically charge lower fees than traditional exchanges (A is wrong).