As an investor, you might be aware of two types of capital markets – primary and secondary. The primary market is the IPO market, whereas the stock exchanges make up the secondary market. But did you know that there are two additional types of capital markets? In fact, the two other types are commonly referred to by traders and investors as the third market and the fourth market respectively. In this article, we’ll explore this type of market in detail including one of the third market examples.
What is the third market?
The third market is essentially a space where shares of companies that are listed in the stock exchanges are traded over-the-counter (OTC) and not through the exchanges themselves.
When investors trade the shares of a company through the third market, they essentially bypass the entire secondary market and its participants such as the broking house and the stock exchange. By doing so, investors can save a lot on brokerage fees, turnover fees, taxes, and other ancillary costs. This allows the purchasing entity to enjoy lower prices than what’s being quoted on stock exchanges.
Who participates in the third market?
The third market is primarily used by large institutional investors like hedge funds, pension funds, and investment banks, among others. These participants typically use the third market to conduct large-scale trades, also known as bulk deals or block deals. That said, they’re not the only ones participating in this market. In more recent years, retail investors and individuals with a high enough net worth have also started to dip their feet in the third market.
Why do institutional investors prefer the third market?
One of the primary reasons institutional investors prefer to conduct bulk deals on the third market is simply the fact that the costs associated with such trades are significantly lower. Since the trades between these investors are so large that they go into millions, the ancillary costs such as the brokerage, taxes, and turnover fees, among others would also go into tens of thousands. Such high additional expenses would not only increase the cost of ownership of the stock, but would also ultimately eat into the profits of the institutional investors.
Let’s take up one of the hypothetical third market examples to better understand the reasoning behind the preference for the third market.
Assume that you’re an investment firm looking to buy 1 lakh shares of Ashok Leyland Limited, which is an exchange-listed entity, at Rs. 100 per share. You could do so via the secondary market. But then, you would have to encounter the various fees and other costs involved in making a trade through the exchange.
Let’s assume that the entire cost associated with an exchange-backed trade comes up to around 4% of the total turnover of the trade.
- This means that you’d have to part with around Rs. 4,00,000 {(1 lakh shares x Rs. 100 per share) x 4%}.
- This increases your cost of ownership from Rs. 100 per share to around Rs. 104 per share {(Rs. 1,00,00,000 + Rs. 4,00,000) ÷ 1 lakh shares}.
- All of this can be avoided by simply making the trade via the third market.
Another major reason is that the third market offers anonymity to both the buyers and sellers. Not all institutional investors would want information about their investments in companies to be in the public domain. Third market gives them the luxury of staying anonymous while they make large investments or liquidate their stake. In fact, the anonymity factor in the third market is so high that neither can the buyer know the identity of the seller, nor can the seller know the identity of the buyer.
Conclusion
Third markets are an integral part of trading and investment. Buying and selling large blocks of a company’s shares with relative ease would not have been made possible without the presence of a third market. Moreover, when huge trades and massive blocks of shares are put up for sale in the secondary market, it would lead to an unwanted spike in the volatility of the counter and could lead to the stock prices skyrocketing and hitting the upper circuit within a short period of time. This would in turn disrupt the smooth flow of trades in the stock market. In a way, the presence of a third market helps alleviate the stress caused on the secondary markets due to bulk deals.
