Investment decisions can be complicated and there are many factors to consider when deciding where to allocate funds. As well as analysing the risks and returns, investors must also assess the liquidity of an investment – meaning how easily they can sell their allocation if they need to. Some assets are highly liquid – such as cash, or shares traded on big exchanges. Others are much harder to exit, such as real estate and private equity markets, and a lack of liquidity carries risk. History has some spectacular examples of illiquidity bringing down the smartest investors, such as Long-Term Capital Management in the 90s.
A lack of liquidity has traditionally been a big barrier to investing in private markets. At some point, liquidity is always needed, but the infrastructure simply hasn’t been in place to support this efficiently. In some cases, there’s been no liquidity at all. Any transactions that did take place did so manually and laboriously – often managed by spreadsheets. To successfully liquidate a position in the secondary market requires the ability to line up all necessary intermediaries to facilitate settlement, from cash custody to individually drafted contracts. In some countries, like the UK, this is even more lengthy and complicated due to additional tax and regulatory overheads, such as stamp duty on secondary transactions in shares of a private company.
Venues for matching buyers and sellers have materialised in recent years, which has created a new route to liquidity. For example, Nasdaq Private Markets has executed over $43 billion in secondary transactions for private companies across more than 600 liquidity programs. But these venues haven’t solved the problem entirely. Execution is still very slow and very expensive.
However, private markets are evolving. Thanks to new technologies, we’re at the start of a new era for liquidity. Distributed ledger technology (DLT) has significantly reduced the time taken from trade execution to settlement in the secondary market. By directly issuing securities as digital tokens registered to a blockchain, a trading venue can publish immediate changes directly to the respective blockchains, capturing changes in ownership of digital assets in real time. This results in instant settlement, without any manual processing required.
Even many of the traditional pain points that required heavy manual processes post-trade - such as stamp duty in certain countries - can now be automated via smart contracts. Functions are carried out automatically when certain conditions are met, streamlining the process, and reducing the risk of human error. Settlement tasks that used to take days to complete can now be finalised in seconds.
More routes to liquidity will inevitably draw more investors to private markets, as it changes the risk profile of the investment. As illiquidity risk falls, the pool of investors widens, bringing more capital into private markets.
Innovative new technologies are breaking down the barriers to liquidity in private markets. If we think ahead to where we could be in just a few years, there’s every reason to believe that transacting in private markets will be just as efficient as transacting in public markets.
You can read Myles's article and further industry insights in the latest edition of The Financial Technologist. Download your free copy here.
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