One of the promises of blockchain-based digital securities (security tokens) that has yet to be realized, is the ability to drive liquidity for private markets.
In 2019 private markets raised $2.9 trillion, or more than double that of public markets at $1.4 trillion, according to the World Federation of Exchanges, and while private markets are much larger and faster growing than public markets, their annualized trading volume remained an astounding 330x less liquid in 2019 compared to public markets, with $0.1 trillion versus $33 trillion respectively.
This represents a tremendous amount of locked up capital that digital securities have the potential to unleash.
Driven by key industry developments and by marrying technology prowess with regulatory acumen, issuers and those involved in capital formation can finally look forward to the benefits that greater liquidity will provide the private capital markets ecosystem. Greater liquidity will breed a more diverse pool of investors, given the large universe that currently cannot afford to have their money locked up.
It also gives issuers access to the “liquidity premium” (which industry estimates calculate at up to 30%) whereby investors are willing to pay up as the ability to trade out of a position freely reduces a myriad of risks.
Admittedly, illiquidity in private markets is sometimes created by design. However, another portion is due to inefficiencies on the trading side, complex regulatory restrictions, lack of price discovery or automated marketplaces where investors can discover assets and trade. Even for those businesses looking to tightly control liquidity, their private securities still require transactions that incur unnecessary costs and time that would be non-existent with digital securities.
Other digitization benefits include back-end efficiencies, more transparency into price discovery, and near-instant clearing and settlement times, all of which decrease transaction costs and replace antiquated and cumbersome manual tasks inherent in the legacy system.
Let us examine why private securities are currently so illiquid and then address how we are working to solve this puzzle. Importantly, while we do not expect, nor forecast that private securities will ever trade with the frequency of public securities, there is ample runway to reduce the annualized trading volumes gap.
Historically, illiquidity enveloping private securities includes private companies having multiple classes of securities, complex regulatory restrictions around initial investment and secondary market trading, and clunky clearing and settlement processes. Furthermore, private securities are poorly digitized which adds unnecessary layers of complexity across all aspects of their life cycle.
One key driver combating these issues are blockchain-enabled securities (or security tokens) since they are programmable and the regulatory and idiosyncratic complexities of private securities are coded into smart contracts. Also, in the same ledger, one can represent cash or cash-like instruments (such as stablecoins) alongside the other asset representing the security, perform clearing and settlement automatically, plus track the beneficial ownership of the securities in real-time.
But technology only solves one part of the problem. The other is navigating the complex regulatory maze and establishing a compliant trading venue for private securities in the U.S., such as an Alternative Trading System (ATS). ATS-sponsored projects have, to date, proven fruitless as very few have launched and those that did failed to drive enough liquidity to achieve critical mass. To compound that problem, some securities trade at a discount to their intrinsic value and instead of enjoying a liquidity premium, issuers are being penalized.
Given this standstill, we concluded that we need to create our own end-to-end solution and went the “buy versus build” route by acquiring an SEC-registered broker-dealer and ATS — allowing for the primary issuance and secondary trading of privately placed securities, including digital asset securities. Following regulatory approval, we will be rolling out a suite of services for private capital markets participants that will enhance the process across the board and establish entirely new standards and best practices.
Our goal is ultimately to bring private markets closer in line with public markets, including a comparable consolidated price quotation system to mirror the national best bid and offer enjoyed by public markets. However, alongside many other benefits we are aiming to germinate, this is a longer-term aspiration that will only occur once static private assets start changing hands. Once we do get to that critical stage of velocity and volume, a more diverse buy-side will emerge including long-term holders, shorter-term speculators, and arbitrageurs.
This is a new era for the private capital markets, and we are finally positioned to wake a sleeping giant by enabling seamless liquidity for both private securities issuers and investors. The path is not without further trials, but we are a critical step closer to the creation of a more vibrant secondaries trading marketplace.
