In this article, we speak to Jeremy Smith, Chief Strategy Officer at SecondMarket, where over 3,000 participants manage over $1 trillion, participating in the world’s largest centralized, independent marketplace and auction platform for illiquid assets from auction rate securities to private company shares, CDO’s, mortgage and asset backed securities.
Vikas Shah, Thought Economics, July 2009
Professor Eugene Fama, in his 1960’s Ph.D. thesis at the University of Chicago Booth Business School hypothesised that, “financial markets are ‘informationally efficient’, or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and rapidly change to reflect new information”. This ‘efficient market hypothesis’ is now widely disregarded, as in the past quarter-century, our advances in technology allow us to observe that markets are not truly efficient as described by Fama, but are efficient to a greater or lesser degree based on many factors in the market.
Contemporary market thinking focuses a lot of attention on the fields of “behavioural finance” and “behavioural economics” which take inspiration and insight from fields including philosophy, psychology, statistics and neo-classical economics. Hersh Shefrin, in his 2002 paper, “Beyond Greed and Fear: Understanding behavioural finance and the psychology of investing” identified three main themes in understanding behavioural markets
Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analysis. (Cognitive Biases)
Framing: The way a problem or decision is presented to the decision maker will affect their action. (Information Biases)
Market inefficiencies: There are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mis-pricings, non-rational decision making, and return anomalies.
More recently, these theories have been extended to create the Adaptive Market Hypothesis, which. “Reconciles theories that imply that the markets are efficient with behavioural alternatives, by applying the principles of evolution - competition, adaptation, and natural selection - to financial interactions” (Andrew Lo).
Keeping these theories in the back of our mind, let us turn attention to the concept of Liquidity in a market.
“A liquid asset has some or more of the following features. It can be sold rapidly, with minimal loss of value, any time within market hours. The essential characteristic of a liquid market is that there are ready and willing buyers and sellers at all times. Another elegant definition of liquidity is the probability that the next trade is executed at a price equal to the last one. A market may be considered deeply liquid if there are ready and willing buyers and sellers in large quantities. This is related to a market depth, where sometimes orders cannot strongly influence prices.”
“An illiquid asset is an asset which is not readily saleable due to uncertainty about its value or lacking a market in which it is regularly traded. The mortgage related assets which resulted in the sub-prime mortgage crisis are examples of illiquid assets as their value is not readily determinable despite being secured by real property. Another example is an asset such as large block of stock, the sale of which affects the market value.”
The latter case, of illiquid assets, has come to the forefront of market commentary as “uncertainty” (the keyword in the definition) has turned many massively liquid markets suddenly the other way (including inter-bank lending, commercial paper, and more). In many cases, the assets considered are still investment grade, and present opportunities for buyer and seller, but the problems caused by heuristics, framing and inefficiencies in these less liquid markets prevent the structured trading necessary to create efficient operations.
SecondMarket (in their own words) are, “the largest centralized marketplace and auction platform for illiquid assets, such as auction-rate securities, bankruptcy claims, collateralized debt obligations, limited partnership interests, private company securities, residential and commercial mortgage-backed securities, restricted securities and block trades in public companies and whole loans. SecondMarket's online auction platform has 3,000 participants, including global financial institutions, hedge funds, private equity firms, mutual funds, corporations and other institutional and accredited investors that collectively manage over $1 trillion in assets available for investment.”
Using an innovative approach, they are aiming to create an efficient market for the trade of these ‘illiquid’ assets, and in a privileged interview, Jeremy Smith (the firms Chief Strategy Officer) talks to us about how they create liquidity and opportunity in these markets.
Q: In your own words, what is second-market and why does it exist?
[Jeremy Smith]: “In the simplest terms, we are an independent marketplace for illiquid assets including, but not limited to, auction rate securities to CDO’s, mortgage backed securities and private company stocks. The key word is “independent”, we are not owned by major buyers or sellers of any of the assets we market, we do not take principal positions to buy or sell assets, we simply provide a market for them to meet. This is an important feature, as in some of the ‘toxic-asset’ markets, one of the biggest problems is that you have market-makers and the market-place acting as the same entity, so for auction rate securities and CDO’s, the banks that connected you with the buyer would buy the asset from you at a discount, and sell to the other party. This provides near instant liquidity, but the problem is for the seller who gets an artificially lowered price. The second problem is more systemic. What happens when the market-makers who are the marketplace go out of business or pull back on their balance sheets? When that happens, the marketplace disappears too. This is a structural flaw where the market-makers and marketplace are the same. If you think of NYSE, CBOE and so forth, you see that you have a marketplace (e.g. NYSE) and a market-maker (e.g. Goldman Sachs), the fact they are different entities keeps the market, to a greater degree, stable.”
Q: How does SecondMarket sit alongside exchanges? And what is the significance of your ‘ecosystem’ approach?
[Jeremy Smith] “The biggest difference, other than legal and regulatory influences, is the types of assets which they, and we, are able and willing to handle. Exchanges are highly automated, with a ‘point, click, execute’ attitude. With these [illiquid assets] you cannot use an automated system; it has to be hybrid to define the necessary efficiency and power. You have to be a market specialist. Of our 125 employees, for example, over 50 are specialists in the specific asset classes they handle, dealing with the unique transaction characteristics for each, and giving “high touch” hand holding, to create liquidity.
Our ecosystem is designed to look at the systemic issues, the transparency if you will. It is a two pronged approach, and is the only way to realistically bring liquidity to these markets. We have an internal transparency team who aggregate and standardise public information and make it available, for free, to buyers and sellers. Not all information is public (e.g. CDO’s) but also, in order to find buyers, you have to provide analytical valuation firepower. Our ecosystem provides all this information, the analytics, research, and valuation systems, to participants on both sides.”
Q: Illiquid assets and instruments have been notoriously hard to price, how does SecondMarket aid in the efficient pricing of these assets and instruments?
[Jeremy Smith] “Transparency is key. The more information you give, the more then bid and ask come together. We provide pricing transparency to buyer and seller showing where similar transactions have happened (or are happening in the case of auctions), bringing pricing into focus.
Another part is education. If we can educate buyers into pricing out there in the market, and why their thinking may not be correct, it also helps us bring liquidity and a narrower bid/ask spread. Improvements in settlement times for established asset classes, for example, restricted securities, which used to take four to six weeks to settle, now take just seven to twelve days, so by definition, we have increased liquidity.
It is, though, important to note that there are controls in these markets, ensuring that sellers, in particular, can control the level of information they give to the market and who can see it. This is essential for certain asset classes”.
Q: Are you seeing any global trends in countries with higher volumes of illiquid assets? And looking at SecondMarket’s site, you have a lot of activity in China, Dubai, Korea etc, how does Asia factor in to your model?
[Jeremy Smith] “I would say, clearly, we see a lot of activity in the USA, closely followed by western Europe. Asia, though, presents an area of great potential, the sheer size of investments held over there gives a medium-term opportunity. Right now, there is not a lot of movement (for economic and cultural reasons) but our efforts there are to penetrate the markets, and ensure we are there when the opportunity develops.”
Turning to sellers of illiquid assets?
Q: Who are the key participants and what are the key advantages to them in participating on SecondMarket?
[Jeremy Smith] “There are marked differences between asset classes. When it comes to auction rate securities and bankruptcy, the bulk of sellers are corporations with bad receivables in a company that went bankrupt (e.g. if company X owed company Y $10,000,000 and went bust, then company Y could sell the debt it is owed). As far as private companies are concerned, usually what you see are employees and early angel investors looking to sell their stakes. Hedge funds and High Net Worth Individuals participate in equity and in other toxic assets where we also have financial institutions and global/regional banks and insurers in the market.
As we discussed above, they have the ability to get better pricing and faster liquidity, and it is because of having these things in a centralised marketplace to aggregate at any time, that the level of participation improves, as does pricing, settlement speed and so forth. “
Turning to the buyers of illiquid assets?
Q: Who are the key participants?
[Jeremy Smith] “As far as buyers are concerned, each asset class is, again, different. The buyers of private company stock may be a venture capitalist, auction rate securities may be a hedge fund, and bankruptcies may be distressed debt buyers. To give you a general sense, around 65% of our buyer base is hedge fund, with the balance split fairly evenly between venture capitalists, pensions and endowments, family offices, global financial institutions, and asset managers.”
Q: Why buy illiquid assets?
[Jeremy Smith] “There are two primary reasons, one being somewhat self serving. Firstly, one unique factor across the majority of investors, is that they are looking for a unique investment opportunity. This [SecondMarket] gives investors access to markets which may have either not been available before, or may have only been available in a small way. Secondly, they [investors] know that they always have a market in which to resell the asset. They may not, previously, have participated because if they invested, they couldn’t easily get out, so they stayed out. Now they can resell these ‘illiquid’ assets, they are more inclined to participate as their risk is somewhat reduced.
Our philosophy is that there should be no such thing as an illiquid asset, there should be “more liquid versus less liquid”, but never illiquid. What we are talking about here is not conducive to environments such as NASDAQ or LSE where billions in liquidity can be created in seconds, but we still aim to provide an adequate level of liquidity.
The complexity and lack of “instant” liquidity also gives these asset classes a higher yield.
It is also important to note that for the asset classes traded, it may not necessarily be the asset which is distressed. In many cases, it is the SELLER of the asset who is distressed, or needs liquidity, the underlying asset itself is fine, but the seller’s own condition creates an opportunity to buy at discount.”
Looking at a few specific markets:
CDO’s and Mortgage Backed Securities
Q: There has been a great deal of negativity directed at these asset classes, how are you seeing investor attitudes here?
[Jeremy Smith] “Seller’s attitudes have been more negative than buyers, simply because they have become upset at carrying assets they don’t want, and can’t get rid of. This is in contrast to the buyers, who see an opportunity and are very excited.
For us as a marketplace, we are seeing a great deal of interest in these assets as buyers, attracted by the high yields (from purchase discount) are also feeling more comfortable trading, as they can resell their assets when they choose, eliminating some elements of risk which had prevented them participating.”
LP Interests & Private Companies:
Q: Interestingly, you also have a market for the ‘vehicles’ used by the VC industry for their investments, along with private company interests directly. Could you tell us more about how these markets work, and what the investor and seller interest and attitude has been like?
[Jeremy Smith] “Most markets are bilateral, insofar as you have a buyer a seller, and that’s it. With LP interests, and private companies, it is a three sided market. You don’t just have a buyer or seller, you have the company (or general partner ‘fund’). So the dynamic really changes because of this characteristic. What we see in terms of attitudes is that private companies and general partners have been reluctant to see these markets form, so we have spent over two years developing our unique ‘private company model’ because of these concerns. The key, we found, was control.
For private companies, for example, we create a micromarket. Typically these companies say, “I’m a private company, private for a reason. I don’t want my shares trading hands between buyers and sellers without me knowing”. The problem is, it already happens. So the choice is, do you want to take control? Or leave the ad-hoc method in place.
In the latter case (ad-hoc) it is useful to note that if employees want to sell shares, they can. Most companies do retain first refusal but in practice (especially at the moment) they don’t want to use capital to buy their own shares back, and would rather invest in market or R&D. The employee therefore calls their accountant, broker, or lawyer who will then sell. Information invariably leaks to the market, and false signals are sent
With our market structure, the company takes control. If you are, for example, linkedin or twitter, you create your own micromarket, you decide who your buyers are (e.g. existing investors? A select group? The whole market), you decide the rules for existing shareholders (how much of their holding can they sell? Do they have a physical value limit? How often can they trade?)
We also, through this model, answer the information problem. By giving control, and privacy, private companies are paradoxically more inclined to release information, as only approved individuals can see it. This creates liquidity and informed bids and in an environment where IPO’s are increasingly difficult, we are seeing many firms opting down our route.
When you have this kind of systemic control, you also get better price stability, which helps fundraising as investors can be more confident in price, transparency, and know they have a market to resell to if required.”
Looking at the future:
Q: How do you see the future for SecondMarket? What ‘markets’ are you bringing on-stream? And what are the key technological innovations you think will have the greatest impact on your business?
[Jeremy Smith] “We currently have around eight markets for illiquid asset classes, with another fifty on our watch-list which we are assessing. In the next twelve months, the marketplaces we have identified in particular include s363 asset sales (a US Bankruptcy asset), private REIT’s, and asset backed securities (including credit card and auto loan securities).
Technology is certainly important to our business, with the regular introduction of add-ons to help analysis and efficiency, but the real crux is the combination of technological and human. Our innovation is predominantly on improving the process and structure of the markets, increasing speed, efficiency, and hence liquidity.”
What we see here is a business model which innovates to tackle the tenets of behavioural finance to create efficiency and opportunity.
By increasing transparency, information, and analysis, SecondMarket have been able to reduce cognitive (heuristic), and framing (information) biases in the market (creating greater participation, and pricing accuracy) and by creating an ecosystem of many thousands of participants, with a great deal of control, they have been able to not only reduce overall risk for participants (almost acting as a pseudo-central counterparty clearing house like LCH.Clearnet) but compensate for the yield, pricing, and rationality anomalies which illiquid markets typically see.
Taking illiquid markets to the extreme, we see companies like “Commercial Intelligence”, who specialise in the recovery of debts from or guaranteed by governments, parastatals or companies in Africa and Asia, here utilising the lack of transparency and liquidity, together with the high perceived level of market-risk, to create high yields and opportunity from highly-illiquid assets.
The more our world becomes interconnected, and the pace of commerce increases, the more we will see that markets ‘behave’ rather than exist, meaning that innovation must take place to ensure continued liquidity and transparency. The lessons of the economic crisis of 08/09 have taught us the importance of these factors, and of the need for continued liquidity, This does signal a change of attitudes in the market, which Geoffrey Moore summarises well describing how “….we were thinking about scale instead of liquidity, ... The correct move now is to redirect the race toward liquidity.”
For more information on SecondMarket, visit them online at: www.secondmarket.com