Secondary Liquidity
Buy the rumor, sell the news
Secondary liquidity is an important feature of investing, which a lot of people seem to ignore, or don’t know much about. But it’s actually a relatively simple concept. Investopedia has a pretty good explanation:
Secondary liquidity refers to the ability of IPO investors to sell shares in the secondary market, that is, to buyers on a public stock exchange. The primary market consists of those institutional investors who buy the issued shares directly from the underwriter and/or syndicate of brokers.
Their explanation is limited to IPOs, but we can generalize this concept a bit: secondary liquidity refers to any situation in which you can sell your securities to a secondary party.
And it turns out that the ability to sell your investment to secondary parties is pretty important! If you buy Facebook or Google shares through Schwab or eTrade or Robinhood, you can rest assured that you can sell those shares to secondary (really, tertiary) parties at some future date because the securities exchanges require that market makers act as intermediaries between buyers and sellers of public securities. This means that whenever you buy a publicly traded company’s stock, you know that there will be a buyer in the future.
But if the security you buy is not publicly traded, there is no guarantee that there will be a future buyer. I bring all of this up because I just posted a Twitter thread about the rise of “fractionalization of expensive things” businesses. These business are enabled by technology which makes managing multiple investors in single expensive items feasible. You can review the thread:
Fractionalizing expensive things can work. Consider Real Estate Investment Trusts (REITs). You can go to your broker right now, and buy REIT shares, safe with the knowledge that, should you want to sell the shares a year from now, you will be able to do so.
But just because you can sell these fractionalized interests doesn’t mean you can sell any fractionalized interest. Consider the recent sale of Beeple’s NFT. The buyer, Vignesh Sundaresan, also known as MetaKovan, paid $69 million in ethereum for the NFT:
“There are going to be hundreds of thousands of people from around the world who are going to adopt this medium, a digitally native medium to monetize art,” Sundaresan said. “There is going to be an economy around it.”
He said that while the art world has been the exclusive purview of wealthy, largely white Western collectors and artists for centuries, NFTs have allowed “artists in the Philippines, Thailand, or India now to make their first $1,000 or $500 on the internet.”
All of this sounds very cool, and for some lucky creators (such as Beeple), NFTs will be a boon. But what about the people who buy these NFTs? What can they do to realize profits on their purchases?
The MetaKovans of the NFT world have two options:
They can hold their NFT until a buyer comes along.
They can fractionalize their NFT and sell interests in the NFT to secondary investors.
The first option depends on there being a secondary buyer waiting to buy the NFT from the original buyer. (And this same issue applies to the secondary buyer: to whom will he sell the NFT?)
The second option offloads the risk of holding the NFT from the original buyer to a set of investors. These investors also rely on a secondary buyer coming along for their NFT interest.
But, as I mention above, there are no market makers for these markets. So there is no guarantee that either an outright owner of an NFT or an owner of interests in an NFT can sell their security at some future point to a secondary buyer. That’s a pretty big risk!
Just because something is expensive and can be fractionalized doesn’t mean that the fractional investment is a good opportunity. If you don’t have market makers ensuring secondary liquidity for expensive, fractionalized assets like sports cards, NFTs, collectible cars, art, or some real estate, then: the people who buy these securities face the very real risk that they’ll never be able to sell their security.
If these securities generated some cash flow, you could argue that there’s no need to sell to a secondary buyer. And that’s true. However, these assets generally do not generate cash flows. (It’s true that some NFTs may be tied to music royalties, which do generate cash flows. The calculation in that case would be different.) If you’re buying an asset which generates no cash flow, then the only hope you have to realize profit from your investment is to find a secondary buyer. Which secondary buyer may not exist!
It’s at this point that people will say to me “Well, [rich guy] bought [piece of art] for [single-digit millions] and sold it for [tens of millions] [after some period of time]! So you’re an idiot!”
But here’s the thing: when we hear about Rich Guy selling a painting or a sports car for millions more than he bought it for a decade ago, we’re ignoring the thousands of collectors who were forced to sell at a loss, or who cannot find buyers for their expensive collectible. When we conclude on the basis of successful investments that expensive things always have secondary buyers, we’re succumbing to survivorship bias.
And that’s where this business model breaks down: fractionalized interests are being sold under the assumption that there will be a future buyer for the interest. While it’s possible that there will be secondary liquidity for a buyer of a fractionalized piece of an expensive thing, there is no guarantee of it.
Whenever I ask the people who run these fractionalize-expensive-things businesses about secondary liquidity, I either get no response or a half-baked response that doesn’t actually answer my question. Until these businesses solve secondary liquidity, I remain skeptical about their viability.