In secondary markets, investors exchange with each other rather than with the issuing entity. Through massive series of independent yet interconnected trades, the secondary market drives the price of securities toward their actual value. Moreover, the secondary markets create additional economic value by allowing more beneficial transactions to occur. The net result is that almost all market prices – interest rates, debt, houses and the values of businesses and entrepreneurs – are more efficiently allocated because of secondary market activity.
Secondary Market for Houses: An Example
In 2011, researchers at the McDonough School of Business at Georgetown University gathered data on new and existing home sales in the United States between 1960 and 2010. They found that existing home sales volume was, on average, between six and 12 times larger than new home sales.
New home sales represent a primary market; a home builder is the original producer and issuer of the house. The first home buyer is the primary buyer. When the primary buyer decides to sell the home, it becomes a secondary market asset. Here, home buyers are negotiating with home buyers; no primary issuer is involved.
Imagine what would happen to the housing market if homes couldn't enter a secondary market. Housing prices would be far less flexible and accurate than they are today, and almost no home buyers would enter the primary market, either. There isn't much incentive to buy a permanently large asset that is locked into a specific location.
Secondary markets are most commonly linked to capital assets such as stocks and bonds. It doesn't take much time to think of plenty of other secondary markets, though. There is a secondary market for used cars. Consignment shops or clothing outlets such as Goodwill are secondary markets for clothing and accessories. Ticket scalpers offer secondary market trades, and eBay is a giant secondary market for all kinds of goods.
Secondary markets exist because the value of an asset changes in a market economy. These changes are driven by technology, individual tastes, depreciation and improvements, and countless other considerations.
Secondary market traders are, almost by definition, economically efficient. Every non-coercive sale of a good involves a seller who values the good less than the price and a buyer who values the good more than the price. Each party benefits from the exchange. Competition between buyers and sellers creates an environment where ask and bid prices meet at the buyers who value the goods most highly relative to demand.
Economic efficiency means that resources are driven to their most valued end. Secondary markets have historically reduced transaction costs, increased trading and promoted better information in markets.
Secondary Capital Markets
The most famous secondary markets are physical locations, even if many secondary trades are now completed electronically from remote locations. The New York, London and Hong Kong stock exchanges are among the most important and influential capital market hubs in the world.
Secondary markets promote safety and security in transactions, since exchanges have an incentive to attract investors by limiting nefarious behavior under their watch. When capital markets are allocated more efficiently and safely, the entire economy benefits.