Public markets and private markets are converging. Find out what other challenges private markets face and how blockchain promises to bring new change that overcomes them.
One of the main differences between public and private markets is the role of intermediaries. In public markets, a number of middlemen are involved in trading securities– examples include stock exchanges, brokers, and investment banks.
In private markets, there are fewer intermediaries because markets are typically dominated by institutional investors with resources to directly invest.
However, there are signs that private markets and public markets are converging. And with the advent of blockchain – which reduces reliance on intermediaries across all capital markets – we’re likely to see even more convergence between the two.
This blog post takes a look at a few of the challenges facing private markets and how blockchain can bring promising new change.
Alongside their benefits, private markets bring many unique challenges. The most obvious is illiquidity; in private markets, investors may find it hard to trade or exchange their securities for cash.
Illiquidity brings with it harder price discovery, which can in turn lead to wide bid-ask spreads (the difference in price between buy orders and sell orders) as well as volatility.
Ultimately, illiquidity can make it hard for investors to exit a position, optimize their portfolio, and make new investments at a fair price.
However, illiquidity isn’t the only problem affecting investors in primary and secondary markets for private securities. Limited trading opportunities, counterparty risk, changing regulation, and convergence with public markets all contribute to a tricky market environment that can be difficult to navigate even for experienced investors.
Because private markets are private, they tend to be exclusive, inaccessible for most investors, and highly opaque.
Knowing about opportunities requires connections, experience, and reputation. Deals tend to be accessible first to elite firms with billions of dollars in private markets compared to companies with newer involvement. Investments also tend to require large commitments that are too expensive for many non-institutional investors. Moreover, the most meaningful private market transactions are executed within their own local markets.
Exacerbating this is the fact that not every possible investor will have the same amount of information about a private company because private companies are not required to comply with regulations on reporting the way that public companies are. This information discrepancy can benefit investors at the exclusion of others or create “alpha-inflation”, where investment allocators create self-referential and subjective benchmark tools to gauge the rate of outperformance.
Lack of information can make implementing a private market investing strategy challenging. Since investors have limited information about a company’s financials or performance, it can be harder for them to make informed choices about whether to invest in or hold onto their shares in that company.
One reason why private markets are popular is because the regulatory environment for private companies features less scrutiny.
Public markets are heavily regulated to protect investors from fraud and prevent insider trading. Public companies must be registered and regularly disclose information about their operations and financial conditions to the public. They also have to comply with rules around accounting and corporate governance.
This has a dampening effect on initial public offerings (IPOs). Not wanting to be scrutinized over quarterly earnings, many private companies delay IPOs while some publicly listed companies have reverted back to private.
Likewise, increased regulation in the banking industry has helped to proliferate the increase in private debt.
However, the largely unrelated nature of private markets can lead to regulatory concerns for investors, who may not always have the ability to know whether their investments or the companies issuing them are compliant with applicable laws and regulations.
Moreover, unrelated marketplaces or lack of oversight for brokers can make transactions riskier, since there is less to prevent the other party in a transaction from defaulting or failing to fulfill their obligations. In other words, investors face the problem of counterparty risk.
Regulators haven’t been oblivious to the increasing popularity of private markets.
Traditionally, private markets have differed from public markets in terms of regulatory requirements. Private markets have until now been largely unregulated and unaffected by these requirements. However, as the number of startups rising to unicorn status swells, so do concerns about companies with vast economic impact operating with opacity.
In response, regulators such as the United States Securities and Exchange Commission (SEC) have been looking to treat private markets and public markets more equally. For example, the SEC is seeking to widen its public reporting regime to include unicorns and other large private companies. That said, implementing the proposed rules are proving to be a sticking point and not necessarily likely to eradicate the issue.
It’s not all about tightening the rules, though. There have also been regulatory changes on the investor side to allow for market growth. For example, the SEC has introduced legislation to allow accredited individual investors and some retail investors to participate in private markets, as well as make crowdfunding more accessible to private companies.
As more casual investors get involved in private markets, it’s likely that regulators will seek to pad private markets with increasing regulation. This is appropriate: regulators want to protect casual investors and assets with systemic importance, such as pension funds. Without these regulations, less experienced and risk-amenable investors may involve themselves in shady deals or with unsavory margins.
Increased regulation could also push resources into less formal and unregulated opportunities– which might actually help fuel the rise of decentralized finance. On the other hand, it could make it harder for promising young companies to establish their footing, particularly in more conservative environments.
Regulation isn’t the only area where public markets and private markets are showing signs of convergence.
A huge indication that the two are becoming more similar is the existence of secondary markets for private investments, including secondary market exchanges for private equity.
The secondary market is where investors purchase securities from other investors instead of the issuing companies. In public markets, the primary market for equity would be when shares are listed for the first time to the public through an IPO. In this case, securities are bought directly from the issuing company. The secondary market would be when those shares are bought and sold between investors in the stock market. Common examples of secondary markets are major stock exchanges NYSE, Nasdaq, and LSE.
Private markets have secondary markets too, although they are less liquid and less regulated. Secondary market exchanges are typically used by employees, founders, and initial investors such as venture capital funds to exchange their equity for cash.
These secondary market exchanges for private equity can be accessed by retail investors to give them access to early and mid-stage startups– AngelList and SeedInvest are two examples.
Secondary exchanges for private equity resemble public stock exchanges. In both cases, equity can be bought and sold directly between the buyer and seller without an intermediary (or to be precise, with the exchange serving as the intermediary).
But is their similarity a good thing?
Some argue that widened participation of secondary private markets will dilute the significance of an investment exit. The idea is that if retail and corporate investors can gain access to early and mid-stage funding rounds, then public markets and private markets will bleed into each other. While this might bring liquidity to private markets, it might be at the expense of venture capital and private equity’s profit upon exit.
An additional concern is that investors in public markets tend to favor cautious and predictable companies, so increased participation in private markets by mainstream investors could regrettably end up throttling innovation or punishing risky start-ups before they can prove their developments beneficial.
As a disruptive technology, this could have a major impact on the blockchain industry. However, it’s more likely that blockchain will also help to resolve many of the challenges facing private markets.
Blockchain technology has the potential to overcome the challenges in private markets by improving liquidity, transparency, and efficiency in private investment transactions.
Here are a few key ways that blockchain can transform private markets:
Through tokenization, blockchain enables fractional ownership and can create a more liquid market for private investments.
Fractionalization enables ownership in private assets to be divided into digital tokens each representing a fraction of the asset that can then be traded on a blockchain exchange.
For issuers, fractionalization can widen the possible pool of investors to include those who may not meet traditional minimum investment requirements, ultimately making it easier to exit a position. For investors, fractionalization lowers the barrier to entry and makes it easier to participate in private markets as well as add new, diverse opportunities to their portfolios.
Moreover, through automation and faster settlement, blockchain can facilitate speedy transactions giving faster access to capital for issuers and quicker liquidity for investors.
Investor participation is also widened from the global nature of the technology, as blockchain allows anyone in the world to participate in private securities.
Blockchain provides a transparent, immutable ledger of transactions that can bring transparency and automation to the reporting process and provide a trusted proof-of-ownership. Ultimately, security tokens can make processes cheaper and less-time consuming, as well as less prone to human error or misconduct. Combined with instant settlement, blockchain can also significantly reduce counterparty risk.
For issuers, tokenization makes it easier to meet requirements set out by current and future regulation. Meanwhile, all participants can benefit from an investing process that is more efficient, more secure, and less opaque.
Blockchain can serve as a single data source that all parties can rely on, leading to less manual intervention and less reliance on intermediaries such as brokers and custodians. Better transparency, automation, and this reduced reliance on manual processes or intermediaries can minimize transaction costs for issuers and investors looking to participate in traditionally expensive private markets.
Overall, by leveraging blockchains such as Polymesh, investors and issuers can benefit from increased liquidity, reduced transaction costs, and better transparency and compliance. For private markets, this means more accessibility, efficiency, and transparency as participants navigate through the above-mentioned challenges in this article. What’s more, private markets only stand to benefit more with innovation as blockchain continues to evolve and mature.