Liquidity, and why the primary market depends on it
The primary market raises capital; the secondary market makes that capital's claim tradable. The syllabus draws the causal arrow explicitly: an active secondary market promotes growth of the primary market and capital formation, because an investor who subscribes to a new issue is assured of a continuous market in which to exit. Take away the exit and the entry dries up.
One structural point recurs in questions. In the primary market the issuer deals directly with investors. In the secondary market the dealings are between investors, and the issuer does not come into the picture at all.
Two ways to trade
| Over-the-counter (OTC) | Exchange traded | |
|---|---|---|
| How trades happen | Negotiated directly between two or more counterparties | Through the stock exchange's electronic order-matching system |
| How trades settle | Directly between the counterparties | Through the clearing corporation |
| Who carries credit risk | Each counterparty, on its own | The clearing corporation, which guarantees settlement to both sides |
Trading is the formal contract to buy or sell a security, and it can happen in either segment. Indian exchanges run electronic order matching that executes trades quickly and efficiently.
Clearing and settlement
Clearing and settlement are the post-trade activities at the core of the equity trade life cycle, and the exam expects you to keep them apart.
OTC transactions settle directly between the parties. For exchange trades, the exchange passes the details of every transaction its brokers executed to the clearing house, which issues an obligation report to brokers and custodians. They must settle their money or securities obligations by the deadlines, and pay penalties if they miss them.
In practice the clearing corporation provides full novation of contracts: it steps in as the buyer to every seller and the seller to every buyer. Each investor's counterparty is therefore the clearing corporation, not the stranger on the other side of the screen, and counterparty risk falls substantially.
Risk management and margins
Guaranteeing every trade exposes the clearing corporation to the risk that a buyer or seller defaults. In the OTC world counterparties are expected to manage credit risk themselves; in the exchange world the clearing corporation manages it by collecting margins.
Two investors trade on the exchange; the buyer's broker fails before pay-in. Without novation the seller would chase a bankrupt counterparty. With novation the clearing corporation owes the seller and must find the money. It can, because the defaulting member had posted initial margin, had its intraday peak exposure collateralised, and had been paying mark-to-market margin on every day the position lost value.
A forward contract negotiated between a farmer and a miller has no clearing corporation behind it. Any question describing a guaranteed settlement, novation or margin calls is describing the exchange-traded segment. Direct negotiation, customised terms and self-managed credit risk describe OTC.
- The secondary market gives liquidity to issued securities; an active secondary market promotes primary market growth because investors know they can exit. Issuers deal with investors only in the primary market.
- OTC trades are negotiated and settled directly between counterparties, who carry their own credit risk. Exchange trades are settled through a clearing corporation that acts as counterparty and guarantees settlement.
- Clearing works out each party's net obligations for a period; settlement delivers the shares and pays the money. Novation makes the clearing corporation buyer to every seller and seller to every buyer.
- To cover its guarantee the clearing corporation collects initial margin (a percentage of trade value based on value at risk), peak margin, and mark-to-market margin (the notional loss on an outstanding trade from price movement).