Part 2/4: The Benefits of a Secondary Market for Certain Stakeholders

May 4, 2017

How the secondary market is successfully serving broker-dealers and their clients.

 

 

Secondary markets inject liquidity into alternative assets where once there was none. Without the benefit of listing on a major exchange like NYSE or NASDAQ, buyers and sellers of alternative assets had to find each other, mutually agree on a transaction price and execute the deal. Broker-dealers were (and are) here to make transactions happen, either as third-party facilitators or as trade participants. The advent of secondary market platforms supporting non-exchange traded assets creates liquidity for a range of alternative assets, including private equity, real estate (private/unlisted REITS, mortgage notes, tax liens, private funds), crowdfunding, private placements, energy tax credits, limited partnerships, and many more. To be clear, the goal of these secondary market platforms, like CFX Markets, is not to prove to your clients that the private asset you suggest is just as liquid as is or her public market allocation, but that you have thought about a possibility in which liquidity may be required, and have a solution that will offer the best possible scenario, using the available neutral secondary markets.

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Broker-Dealers

BDs initiate, underwrite and facilitate transactions, which means they create or source capital for IPOs, and private security offerings. When selling securities to investors, they must be mindful of their client’s objectives and risk profile, more now than ever as a result of the Department of Labor ruling.  Whatever the eventual outcome of the current Department of Labor’s new rule, we can all agree that BDs should and must always act for the benefit of clients, even when also pursuing self-interests.

At first blush, BDs might consider secondary marketplaces as problematic, specifically those that believe their role is simply to get paid on exploiting inefficiency. A more nuanced view is that secondary market platforms provide valuable services that help BDs in several ways they should support:

1. Clear product: Under the new Fiduciary Rule, a certain portion of the holdings of BDs and their clients might no longer be deemed appropriate. Secondary markets give BDs an opportunity to dispose of these holdings, freeing up capital to purchase compliant assets. Because of the secondary markets’ transfer mechanism, the selling prices of non-compliant assets are objective and market-driven. These are transparent prices that can be shown to clients as the best available option, limiting any negative reaction from clients.

2. Increase transaction volume: The JOBS Act, through its changes to the 506(c) Rule and to Regulation A, as well as the advent of crowdfunding, opened the private security market to non-accredited investors, and increased the scope of marketing to accredited ones. The general solicitation clause of 506(c) give BDs a powerful toolbox to educate clients about exotic asset classes, while the secondary market platforms help ensure that clients will not be stuck with unmarketable private securities following the one-year holding period – an important consideration for fiduciaries. Secondary market platforms can fee-share with BDs who deliver client order flow, which is a triple-win for BD, platform and client.

3. Advise clients: A criticism sometimes hurled at BDs is that they might be tempted to avoid tying up clients’ assets in illiquid investments because it cuts turnover and the resulting commissions. The potential conflict is that BDs receive commissions based on transaction volume, so that any strategy emphasizing illiquid assets works against BDs. The secondary markets moot this criticism by making illiquid assets more liquid, enabling BDs to give unconflicted advice to clients about alternative investments. The secondary markets also allow BDs to give ongoing advice about alternative positions.

4. Better valuation: The best way to value an asset is to put it up for marketplace sale. Illiquid assets don’t benefit from this valuation method unless they can enter the sales process via a secondary market. Valuations based on other criteria, such as historical prices, can be extremely inaccurate, which makes it impossible to determine a valid return on investment. If an asset is overvalued, ROI is too high and investors are tempted to maintain holdings in this asset. Market-based ROIs are accurate, and might cause investors to reallocate their holdings to higher-returning assets, creating order volume and commissions, while also benefiting the client through appropriate allocation.

Secondary markets give broker-dealers new options regarding illiquid alternative assets, including inventory management, impartial valuation, higher order flow and unbiased advice. The JOBS Act has helped grow the audience for private securities, while secondary markets have reduced their risk profile to allow for better investing at all levels of the economic scale.

 



 

CFX Markets

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