On November 18, 2011 (after the bubble burst for dotcoms), I was jolted out of retirement. What event caused this shock? Nothing less than the new future of capital markets. On that date, Congress instructed the SEC to permit issuers and brokers to use the internet when raising funds for startups and other businesses. Lawmakers in the House initiated this as the Entrepreneur Access to Capital Act, which was later renamed the JOBS Act when it reached the Senate and was ultimately signed by the president.
Why the massive potential? The legislation created the opportunity for companies to use the internet to raise capital from accredited and retail investors, and set the stage for disruption in capital markets. The core features of the act were to improve access to capital for entrepreneurs, startups and small businesses that were often overlooked by more conventional capital sources, as well as to democratize investment opportunities that had previously been reserved only for the very rich.
The Regulations Problems
Regulations, including Sarbanes-Oxley and Dodd-Frank and many others, make it difficult for businesses and real estate funds to go public. And for brokers, the rules for decimalization, suitability, and research make it nearly impossible for them to create markets or sell small-cap stocks. The result? The public markets are effectively reserved for only the biggest businesses, which can use the markets to raise capital and enable their shareholders to enjoy forms of liquidity.
Innovation Abounds—but Issues Remain
There is now an explosion of broker/dealers filing with the SEC to build the next generation of alternative trading system platforms. These firms see the promise of active and liquid markets for real estate interests and private company securities. But we are not yet in the mainstream, or even in the launch stage. There are some (surmountable) roadblocks, including:
- Custody Requirements: Real estate interests and private securities must be held in custody to create efficient markets and support trade settlement. The problem? Traditional clearing brokers won’t custody private securities due to settlement system noncompatibility, unattractively low volumes, and the regulatory and litigation concerns. They need to comply with 15c3-1, 15c3-3 and other regulations. The proposed solutions are inefficient and won’t support the formation of these new trading markets.
- Lacking Diligence: Investor data abounds when you click on a symbol for PFE or APPL. There are all types of information and disclosures that serve as a guide for evaluating that investment. In the private markets, this data does not exist. The ATSs therefore need to build databases from scratch and include offering docs, payment histories, financial disclosures and any available third-party research.
- Making Good Deliveries: On an ATS, the counterparties need assurances that the seller owns the securities being sold and the buyer has the necessary clear funds to make the purchase. And that the parties can have confidence they will receive what was promised. Without custodians, you can’t do this at scale.
- Finding the Buyers: Locating a seller for private securities or real estate interests is relatively easy. But locating buyers is another story. The lofty goals of the new ATSs are tempered by the need to build core groups of buyers for private securities. This is not an impossibility, and it will happen, but it will require significant investment in marketing and time to take shape.
- Overcoming Tradability Regs: Reg D securities must generally be held for at least a year before trading, and nonreporting businesses need to maintain less than 2,000 shareholders of record unless they register pursuant to SEC rule 12g. These regulations and exemptions require careful study, and ATSs must invest time and resources understanding all of these issues before they move forward at scale.
- Listing Hurdles: For an ATS to gain broad adoption, sellers must have the ability to easily list for-sale securities. And the ATSs must provide the necessary data for buy-side investor due diligence and for transaction initiation. They’ll also need streamlined documentation requirements and some financial reporting obligations.
Elegant Technology Solutions
Many will rush into the ATS space—big players and scrappy entrepreneurs alike. Then comes segmentation and consolidation as the market matures. And from there we are potentially looking at the next NASDAQ or OTC markets as the opportunities for capital and liquidity reach unparalleled heights.
Scott Purcell is the CEO and chief trust officer of Prime Trust, an API-enabled B2B open-banking financial solutions provider.
