Level 1 CFA® Exam:
Primary & Secondary Security Markets

Last updated: January 05, 2023

Primary Security Markets Explained for CFA Exam

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A primary market is one in which securities are sold by their issuers. If an issuer publicly sells his securities for the first time, we say it's an initial public offering. Any subsequent attempts to sell securities that were previously issued are called seasoned offerings. Seasoned offerings just like initial public offerings are made in primary markets.

On the other hand, trades between investors are made in secondary markets.

If a public company intends to raise the capital, it can achieve it by:

  • public offerings,
  • private placements,
  • shelf registrations,
  • dividend reinvestment plans, and
  • rights offerings.

CFA Exam: Public Offerings

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Initial public offerings are often assisted by investment banks. They provide consultancy services and build a book of orders. Book building is about potential investors subscribing for the stock before the offering price is announced. The purpose of this procedure is to see what is the demand for the offering.


Private Placement and Other Primary Market Concepts

Private Placement

A private placement is addressed to a specified group of qualified investors who have both the capital and knowledge necessary to properly assess the risk involved. Returns on private placements are usually higher than those on public offerings. When it comes to private placements, there is less information about the issuing corporation disclosed than in the case of public offerings. This is why private placements are far less expensive.

Shelf Registration

Another way in which a company can sell its shares is through a shelf registration. This process requires that the issuers go through all the formalities required in the case of a regular offering, but the sale itself is spread over time and happens in multiple transactions, depending on the company's demand for capital. In the case of a shelf registration, the issuer creates only a single prospectus and shares are sold directly into secondary market.


CFA Exam: Secondary Security Markets & Market Structures

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The term 'secondary market' actually encompasses many ways of trading that differ with respect to the parties involved, manner of trading, and settlement and clearing. Now we're going to discuss various market structures that allow trading.

Trading Sessions

A basic classification of markets according to when trades can be made distinguishes between call markets and continuous trading markets.

In a continuous trading market (which is the most common type of market), transactions take place at any time when the market is open.

In a call market, trading sessions are called at a specified time and trading is possible only at that time. Call markets are usually arranged once a day and are completely illiquid between trading sessions. However, since all market liquidity is accumulated in one place at the same time, investors can easily arrange trades. How are prices set in a call market? That's done using single price auctions in which a price that maximises the trading volume based on all buy and sell orders is selected. The price then applies to all orders. Note that a similar procedure opens trading in continuous trading markets.

Execution Mechanisms

Another distinction between markets depends on the mechanisms of order execution.

We distinguish among three types of markets:

  • quote-driven markets,
  • brokered markets, and
  • order-driven markets.

A quote-driven market is used for instruments such as currencies or bonds. In this kind of market, one party to a transaction is a dealer that quotes purchase and sale prices. A dealer usually operates on behalf of a financial institution, such as an investment bank.
Brokers are responsible for finding buyers and sellers to take the opposite sides of a trade in a brokered market. As for the assets traded in the brokered market, they're usually unique goods, which is why they are rather illiquid and there aren't many potential buyers, for example real estate or works of art.

In order-driven markets, trades are executed based on orders submitted by investors or dealers, with the orders specifying the price at which they're willing to buy or sell securities. All exchanges use order-driven transaction systems.

There are two categories of rules for arranging and executing transactions in order-driven markets:

  • order matching rules and
  • trade pricing rules.

Order Matching Rules

The fundamental rule is that buy orders with the highest limit are matched with sell orders with the lowest limit. If the limit price of a buy order is higher than the limit price of a sell order, a transaction is made and the volume of the transaction is the same as the volume of the smaller of the two orders.

Orders are filled based on clearly defined procedures called order precedence hierarchy:

  • One major rule for filling orders is the price priority rule that states that the first orders to be filled are the highest priced buy orders and the lowest priced sell orders.
  • The secondary precedence rule states that where two buy orders or two sell orders with the same limit price are placed, the one placed earlier will be filled first.
  • Additionally, where a hidden or partially hidden order is placed, its displayed quantity at a particular price has priority.

Trade Pricing Rules

Once the first stage of a trade is completed, that is orders are matched, a price needs to be set for the trade. Given the nature of call markets regarding price determination, the uniform pricing rule applies in these markets. This means that all orders are filled at the same price. As you already know, prices are set at a level that ensures the maximum possible volume of all trades.

In continuous trading markets, trade prices are set based on the discriminatory pricing rule. This rule states that the trade price is the price of the order that was placed first.

Lesson Video

CFA Exam: Well-Functioning Financial System

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For market participants to achieve their financial objectives, financial systems must have a number of qualities.

  1. The movement of money from the present to the future mustn't be hindered in any way, and rates of return that can be earned as compensation for risk should reflect its level.
  2. Businesses should have access to capital allowing them to grow.
  3. Hedgers should be able to trade in overseas markets to hedge against risk.
  4. Market participants should be free to trade one class of assets for another.

If the conditions are met, we say that the financial markets that make up a financial system are complete markets.


CFA Exam: Market Regulation

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For a financial market to function properly, regulators must be in place to ensure that regulations are observed by all participants. There are two types of such regulators. We distinguish:

  • government agencies, and
  • practitioner organizations (made up by market participants selected under special procedures).

Since in financial markets it is difficult to detect offenders and potential punishments are relatively lenient, some financial market participants engage in dishonest and illegal practices. The more complicated the traded asset, the more frequent fraud is.

One of the important roles of regulators is to prevent negligence. You need to know that it's actually negligence, and not intentional actions that causes most problems in global financial markets.

Regulators are not only supposed to make sure that law is abided by, but also to engage in educational activity. This is important because the greater the inequality in the knowledge available to market participants, the greater the number of offences. It takes a lot of economic awareness not to fall victim to a crime, and knowledge of economics is systematically growing thanks to regulators' activity.

Investors often make investment decisions based on advice from agents such as financial advisers and investment managers. However, it's difficult for an inexperienced investor to properly judge the quality of their services, which often leads to abuse. To reduce the risk of this happening, regulators introduce standards of competence for agents. Those standards are the minimum requirements that should be met for an agent to operate in the market.

Regulators also ensure that market participants observe rules governing the minimum level of capital to be kept by financial institutions through investments. The capital is necessary for firms to be able to meet their obligations towards market participants at any time.

Level 1 CFA Exam Takeaways: Primary and Secondary Security Markets

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  1. A primary market is one in which securities are sold by their issuers.
  2. If a trade is made between two parties none of which is the issuer of the traded security, we deal with a secondary market.
  3. As regards secondary markets, we distinguish quote-driven markets, order-driven markets, and brokered markets.
  4. There are two categories of rules for arranging and executing transactions in order-driven markets: order matching rules and trade pricing rules.
  5. A financial system will be operationally efficient if the costs of the processes we've just mentioned are low.
  6. A financial system will be informationally efficient if all information on assets is reflected in their prices.
  7. Regulators make sure that regulations are observed, promote fair trading, and educate investors.