Types of Markets

Securities do not all trade in the same place. Where a trade happens depends on where the security is in its life, and the first split the exam wants you to understand is the one between the primary market and the secondary market.

The primary market: where securities are born

The primary market is where new securities are issued for the first time. When a company runs an IPO, those shares are sold in the primary market, and the money goes to the issuer. This is the market governed mainly by the Securities Act of 1933, the disclosure law for new issues.

The secondary market: where they trade afterward

Once securities exist, investors buy and sell them among themselves in the secondary market. The NYSE, Nasdaq, and the OTC markets are all secondary markets. The key distinction: in a secondary trade the issuer gets nothing, the money simply moves from one investor to another. This is the world of the Securities Exchange Act of 1934.

Zoom into the secondary market and you find a finer classification the exam loves: the four markets. They are not so much four different places as four different ways a trade can happen, and each has its own pricing style.

First market: listed securities on their exchange

The first market is the obvious one: exchange-listed securities trading on the exchange where they are listed, like an NYSE-listed stock changing hands on the NYSE. Both the NYSE and Nasdaq are registered national securities exchanges, and pricing here is auction-driven.

Second market: unlisted securities over the counter

The second market is the over-the-counter (OTC) world, where unlisted securities trade through a dealer network rather than on an exchange. It covers the OTC Pink (the old Pink Sheets), the OTC Bulletin Board, and OTC trading in corporate and municipal bonds. Pricing is negotiated directly between dealers.

Third market: listed securities, traded OTC

The third market is the one that trips people up: exchange-listed securities traded off the exchange, in the OTC market. An institution might trade an NYSE-listed stock through an OTC dealer instead of on the floor, often to save on fees. Pricing here is competitive.

Fourth market: institution to institution, no broker

The fourth market is direct institution-to-institution trading with no broker-dealer in the middle. These trades run through ECNs and dark pools (the alternative trading systems we cover next), so the parties pay platform fees rather than broker commissions. Pricing is direct.

Not every trade happens on an exchange or through a traditional dealer. An Alternative Trading System (ATS) is a non-exchange venue that simply matches buyers with sellers. ATSs are regulated under the SEC's Regulation ATS, and they must register as broker-dealers. Two kinds matter for the exam.

Electronic Communication Networks (ECNs)

An ECN is an automated system that matches buy and sell orders electronically. ECNs let people trade outside normal exchange hours (this is what powers after-hours trading), display orders anonymously, and fall under the ATS rules. They are a workhorse of the fourth market.

Dark pools

A dark pool is a private ATS built for institutions that need to move large blocks of stock without showing their orders to the public first. The reason is market impact: if a pension fund openly posted an order to sell five million shares, the price would slide before the order ever filled. By hiding the order until after execution, a dark pool protects the institution from that slippage. That same lack of pre-trade transparency is exactly what draws regulatory scrutiny, and like all ATSs, dark pools answer to the SEC under Regulation ATS.

With trades scattered across exchanges and ATSs, something has to tie all those venues together so investors get fair prices. Two pieces of plumbing do that job.

The Securities Information Processor (SIP) and the NBBO

The SIP is the central system that gathers real-time quote and trade data from every exchange and market center and publishes it in one consolidated feed. Its most important output is the National Best Bid and Offer (NBBO), the best available bid and ask across all venues at any given moment. The NBBO is the benchmark every execution is measured against.

Regulation NMS

Regulation NMS (for National Market System) is the rulebook that keeps the venues honest. Three of its rules show up on the exam:

• The Order Protection Rule (Rule 611) bans trade-throughs. A trade cannot be executed at a worse price when a better price is available somewhere else; orders must reach the best available price across all exchanges. This is the rule the exam tests most.
• The Access Rule requires fair, non-discriminatory access to those quotations.
• The Sub-Penny Rule bars quoting in increments smaller than a penny for stocks priced at or above $1.00.