46 The Security Markets

Types of stock market transactions include IPO, secondary market offerings, secondary markets, private placement, and stock repurchase.

Types of Stock Market Transactions

IPO

An initial public offering (IPO), or stock market launch, is a type of public offering where shares of stock in a company are sold to the general public, on a securities exchange, for the first time. Through this process, a private company transforms into a public company. Initial public offerings are used by companies to raise expansion capital, monetize the investments of early private investors, and become publicly traded enterprises.

A company selling shares is never required to repay the capital to its public investors. After the IPO, when shares are traded freely in the open market, money passes between public investors.

When a company lists its securities on a public exchange, the money paid by the investing public for the newly issued shares goes directly to the company (primary offering) as well as to any early private investors who opt to sell all or a portion of their holdings (secondary offering) as part of the larger IPO. An IPO, therefore, allows a company to tap into a wide pool of potential investors to provide itself with capital for future growth, repayment of debt, or working capital.

Although an IPO offers many advantages, there are also significant disadvantages. Chief among these are the costs associated with the process, and the requirement to disclose certain information that could prove helpful to competitors, or create difficulties with vendors. Details of the proposed offering are disclosed to potential purchasers in the form of a lengthy document known as a prospectus.

Most companies undertaking an IPO do so with the assistance of an investment banking firm acting in the capacity of an underwriter. Underwriters provide a valuable service, which includes help with correctly assessing the value of shares (share price), and establishing a public market for shares (initial sale ).

Secondary market offering

A secondary market offering, according to the U.S. Financial Industry Regulatory Authority (FINRA), is a registered offering of a large block of a security that has been previously issued to the public. The blocks being offered may have been held by large investors or institutions, and proceeds of the sale go to those holders, not the issuing company. This is also sometimes called secondary distribution.

A secondary offering is not dilutive to existing shareholders, since no new shares are created. The proceeds from the sale of the securities do not benefit the issuing company in any way. The offered shares are privately held by shareholders of the issuing company, which may be directors or other insiders (such as venture capitalists) who may be looking to diversify their holdings. Usually, however, the increase in available shares allows more institutions to take non-trivial positions in the issuing company which may benefit the trading liquidity of the issuing company’s shares.

Transactions on Secondary Market

After the initial issuance, investors can purchase from other investors in the secondary market. In the secondary market, securities are sold by and transferred from one investor or speculator to another. It is therefore important that the secondary market be highly liquid. As a general rule, the greater the number of investors that participate in a given marketplace, and the greater the centralization of that marketplace, the more liquid the market.

Private placement

Private placement (or non-public offering) is a funding round of securities which are sold not through a public offering, but rather through a private offering, mostly to a small number of chosen investors. “Private placement” usually refers to the non-public offering of shares in a public company (since, of course, any offering of shares in a private company is and can only be a private offering).

Stock repurchase

Stock repurchase (or share buyback) is the reacquisition by a company of its own stock. In some countries, including the U.S. and the UK, a corporation can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company’s outstanding equity; that is, cash is exchanged for a reduction in the number of shares outstanding. The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance.

Companies making profits typically have two uses for those profits. Firstly, some part of profits can be distributed to shareholders in the form of dividends or stock repurchases. The remainder, termed stockholder ‘s equity, are kept inside the company and used for investing in the future of the company. If companies can reinvest most of their retained earnings profitably, then they may do so. However, sometimes companies may find that some or all of their retained earnings cannot be reinvested to produce acceptable returns.

Types of Market Organizations

There are three main types of market organization that facilitate trading of securities: auction market, brokered market, and dealer market.

Security Markets

The securities market is an economic institute where sale and purchase transactions of securities between subjects of economy take place according to demand and supply. These can be broken down into different types based on what is being traded. They are also differentiated by structure. The primary market is the part of the capital markets that deals with the issue of new securities. The secondary market, also known as the aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold. After the initial issuance, investors can purchase from other investors in the secondary market.

The major stock exchanges are the most visible example of liquid secondary markets – in this case, for stocks of publicly traded companies. Exchanges such as the New York Stock Exchange, Nasdaq, and the American Stock Exchange provide a centralized, liquid secondary market for the investors who own stocks that trade on those exchanges. Most bonds and structured products trade “over the counter,” or by phoning the bond desk of one’s broker-dealer. Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities, or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.

In the U.S., over-the-counter trading in stock is carried out by market makers that make markets in OTCBB and Pink Sheets securities using inter-dealer quotation services such as Pink Quote (operated by Pink OTC Markets) and the OTC Bulletin Board (OTCBB). OTC stocks are not usually listed nor traded on any stock exchanges, although exchange listed stocks can be traded OTC on the third market. An over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. Forwards and swaps are prime examples of such contracts.

Types of Market Organization

There are three main types of market organization that facilitate the trading of securities: an auction market, a brokered market, and a dealer market. Hybrids of these types may also exist.

In the auction market format, buyers and sellers are brought together directly, announcing the prices at which they are willing to buy or sell securities. “Orders” are centralized by the market, so highest bidders and lowest sellers are exposed to each other. The New York Stock Exchange is a notable secondary market that is structured as an auction market. The NYSE trades in a continuous auction format, where traders can execute stock transactions on behalf of investors. They will gather around the appropriate post where a “specialist” acts as an auctioneer in an open outcry auction market environment to bring buyers and sellers together and to manage the actual auction.

Broker markets are usually only used for securities that have no public market, necessitating the middleman in the form of a broker. When a client asks their broker to fill an order, it is the broker’s job to track down trading partners. The broker provides information about potential buyers and sellers and earns a commission in return. Municipal bonds are often traded in this way.

Dealer markets, also called quote-driven markets, centers on market-makers (or dealers) who provide the service of continuously bidding for securities that investors want to sell and offering securities that investors want to buy. This person or company quotes both a buy and a sell price in a financial instrument or commodity held in inventory. Dealers earn a profit on the bid-offer spread. Most foreign exchange trading firms are market makers and so are many banks. The market maker sells to and buys from its clients and is compensated by means of price differentials for the service of providing liquidity, reducing transaction costs and facilitating trade. The NASDAQ, many OTC markets, and the Forex are structured this way.

 

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