Accredited investors

Here’s the way public stock markets work. If you like Apple Inc.’s stock, you can buy some. It costs $198.45 per share. Buy as many shares as you want. If Warren Buffett likes Apple’s stock, he can buy some. It costs $198.45 per share. He can buy as many shares as he wants. Probably more than you! You get the same shares. It’s the same company. Mostly you pay the same price. 1  He might be able to get better information than you do—like, if he called the company to ask questions, someone would call him back—but actually most of the information that either of you would want is easily available in Apple’s public financial reports and securities filings. I often make fun of the idea that public stock markets offer a “level playing field,” and of course it is true that sophisticated professional investors tend to have information and capabilities that retail hobbyist investors lack. But they are playing the same sport.

Here is a simple model for how private stock markets work. I mean, “private stock markets” is not quite the right phrase; private stocks tend not to trade frequently on “markets.” But in the U.S., there are private companies that issue stock in private placements to “ accredited investors,” mostly meaning people—roughly 16 million of them—who have more than $1 million of assets or who make more than $200,000 per year. Here is my model:

1. Some really hot private company wants to raise $100 million. It calls a dozen prominent venture capitalists. They all compete to offer it the best terms and to show off their capabilities in advising and nurturing hot startups. The company chooses the best terms from the best VC and raises the $100 million from one or a handful of them.
2. Some slightly less hot private company wants to raise $100 million. VCs aren’t fighting to get into the deal, but the company goes around pitching VCs and gets a few of them to believe in its vision. It raises $100 million from perfectly fine VCs on perfectly fine terms.
3. Some lukewarm private company wants to raise $100 million. It struggles to convince prominent VCs when it pitches them, but is able to find a few outliers: people who left big VC firms and are setting up on their own, people who got rich working at other startups and are now trying their luck as investors, etc. It raises $100 million from a motley assortment of venture-capitalist-ish funders at terms that reflect the riskiness of the operation.
4. Some ice cold private company wants to raise $100 million. It hires a call center in Florida to dial up all of the dentists in America and ask them to invest $10,000 each. It raises $79.4 million in small lots from dentists, good enough, whatever.

Look look look this is not a perfect model, it is not always right, some tiny startups that are neglected by prominent VCs and raise their money in small lots from dentists end up being huge home runs, and then those dentists get very rich. But in general it seems reasonable to expect a sort of waterfall of private funding, in which most of the clear home-run ideas will tend to get funded by sophisticated professional investors who are able to write large checks and provide useful expertise to young companies, while most of the ideas that get funded by cold-calling dentists will be the ones that sophisticated professionals would pass on.

Not always! And sometimes the sophisticated professionals are wrong! But the point is:

1. Small-time but accredited individual investors are not generally offered the same private investing opportunities as big sophisticated professional investment funds, and
2. There might be systematic differences in the quality of those offerings.

It is easy to miss this because it is not how the public markets work: In the public markets, small-time individuals and big institutions mostly are offered the same investment opportunities, and when they are treated differently people are scandalized. But the whole point of private markets is that they are private, they are not open to everyone on the same terms, and companies get to decide whom to sell stock to and on what terms.

A popular worry these days is that all of the growth in U.S. equity markets is actually in private markets. Companies now raise lots of money privately to fund their growth, and don’t go public until they are already huge and mature and worth tens of billions of dollars. Regular mom-and-pop investors aren’t “accredited” and so aren’t allowed to invest in those companies until they go public, at which point all of their explosive growth is behind them. The rich—big private investors, venture-capital funds—can invest in dynamic growing companies and get richer; the middle class are stuck with boring low-growth public companies.

One proposal to fix this is to let more regular people invest in private markets:

The prospect of such a major change was raised Tuesday by the U.S. Securities and Exchange Commission, which said it would seek public comment on whether it should ease long-standing restrictions that prevent regular Americans from investing like the wealthy can.

Advocates for expanding the pool say current rules prevent mom-and-pop from investing in companies like Uber Technologies Inc. and Facebook Inc. at the most lucrative stage when such firms are fast-growing startups. Yet skeptics say they’re worried about unsophisticated investors getting fleeced.

The SEC’s concept release is quite broad, about all sorts of “Ways to Harmonize Private Securities Offering Exemptions”; it is not mainly focused on lowering the bar for “accredited investors” and letting more people invest in private offerings. 2  But it does spend some time on that idea. I get it! Private markets are where the growth is, so why not let middle-class people invest in private markets? I am just not sure that the private markets that middle-class people would get to invest in would be quite the same private markets as the ones where rich sophisticated investors are getting all that growth.

That said, many of the actual ideas—they are not really proposals, just ideas for further discussion—in the SEC’s release seem fine. The current accredited investor standard, which requires individuals to have $1 million of non-house assets or make more than $200,000 per year, is kind of random and not a great way of assessing either investment sophistication or ability to bear losses. 3  The SEC asks whether it should “expand the pool of accredited investors to include individuals who have passed examinations that test their knowledge and understanding in the areas of securities and investing,” or “explore ways to allow participation by potential investors with specific industry or issuer knowledge or expertise who would not otherwise be considered accredited investors,” and sure, yes, why not.

But there’s one idea that I really like: In response to prior SEC releases, commenters suggested that the SEC should “allow individuals to self-certify their status as accredited investors.” Or as the SEC suggests now: “Permit individuals, after receiving disclosure about the risks, to opt into being accredited investors.” They don’t emphasize this one; it comes at the end of the list of ideas, and there is not much discussion of the pros and cons or of how exactly it would work. But it is really the correct approach. In fact, I have proposed this idea previously as the Certificate of Dumb Investment:

To get that certificate, you sign a form. The form is one page with a lot of white space. It says in very large letters: “I want to buy a dumb investment. I understand that the person selling it will almost certainly steal all my money, and that I would almost certainly be better off just buying index funds, but I want to do this dumb thing anyway. I agree that I will never, under any circumstances, complain to anyone when this investment inevitably goes wrong. I understand that violating this agreement is a felony.”

If you want to invest in weird private investments and do a lot of careful due diligence to find the good ones, fine, good, have at it, the SEC shouldn’t stop you. If you want to invest a small portion of your money in weird private investments as lottery tickets, knowing that a lot of them will go bad but hoping some might pay off, fine, great, go for it, it’s a free country. But if you want to invest all of your money in weird private investments because your cousin told you about a cool new app, someone should tell you not to. They shouldn’t necessarily stop you, but they should tell you it’s a bad idea, and only let you do it once you have been forced to confront the likelihood that you’re being a fool.

So I am pleased to see that the SEC is at least considering the Certificate of Dumb Investment. 4  The concept release will be open for public comment, so if you agree that this is the right way to regulate private investments, maybe let the SEC know. 

On the other hand

I just got through saying that big sophisticated investors will get shown better deals than small naive investors, but there are some limits. If you run a $20 billion investment fund, you won’t look at a lot of $10 million investment opportunities, because you’ll be busy enough looking at $1 billion opportunities to try to actually get your money deployed. It’s possible that there’s more growth available in smallish investments than there is in companies that are already large. This is a well-known problem in many areas of finance—plenty of hedge funds have a great strategy, grow rapidly, run out of capacity in that strategy, and drift into mediocre other ideas—but here is a Wall Street Journal article about how private-equity megafunds tend to have so-so returns:

The reasons behind the trend are simple: Bigger funds generally have to find bigger targets to invest their money, which means they have fewer options. It tends to be more difficult to broadly implement new operating strategies at larger companies than at smaller ones. Megafunds, as a result, are often buying the market.

The smaller the fund is, the less its returns tend to be tied to the broader market. U.S. funds of less than $350 million had a correlation of 0.38 with the S&P 500, compared with 0.62 for funds $10 billion or more, according to Cambridge.

Or, if you would like that insight in the form of a perfect quote:

“They are definitely serving a role in your portfolio, but it may not be the role you think they are serving,” said Andrea Auerbach, head of the global private-investments group at Cambridge, in an interview. “Size is the frenemy of performance.”

Libra

I gave Facebook Inc.’s planned Libra cryptocurrency project sort of a maximalist treatment yesterday, imagining what it might be like for Facebook to succeed in its grand vision of building a currency that competes with and perhaps supplants national currencies. But it’s worth saying that right now Libra is just a set of early-stage plans for launching a payments system next year that will let you send money to your friends over Facebook. You can’t get too optimistic, or too frightened, now. Maybe it will rapidly displace all other currencies, become the foundation of the world economic system, and give Mark Zuckerberg arbitrary and absolute power over all human activity in perpetuity. Maybe they’ll forget to build it. Maybe the members of the Libra Association will have a bitter and unresolvable dispute over fonts on the Libra website and the whole thing will fall apart before it launches. Maybe it will end up being a small niche version of PayPal or Venmo, but denominated in a weird annoying quasi-currency. I don’t know! 

Still, the point of Libra’s big launch probably was to encourage a certain maximalism. And it worked!

Facebook Inc.’s plans to create a new cryptocurrency that can be used for everything from commerce to money transfers is facing pushback from angry U.S. lawmakers.

House Financial Services Committee Chairwoman Maxine Waters urged the company to halt development of the token until Congress and regulators can examine it. Other lawmakers demanded hearings and questioned whether the coin, called Libra, will have appropriate oversight.

Oops! If Facebook had been like “hey in a year we’re gonna let you send money to your friends over Facebook,” there would probably not be hearings. But a message like “all currencies are obsolete, everything will be Facebook now” tends to get a lot of attention, positive but also negative.

I think it is fair to say that a lot of financial companies have spent the last few years looking at the giant internet companies with deep envy. Banks are comprehensively and controversially regulated; their importance to society and the economy is pretty well understood, and the public interest in their safe and sensible operation is obvious, so there is a lot of regulation to keep them operating in the public interest, and a lot of bitter disputes over what that regulation should be. The internet companies are … like … it was not obvious a decade ago that sharing baby pictures online was a matter of grave public importance? Compared to finance, at least, the big tech companies have been operating in more or less a regulatory vacuum, though that is obviously changing rapidly as privacy and antitrust and other regulation tries to catch up to where the tech companies are.

But it is sort of obliging that Facebook will just become a financial company! That’s where the regulation was anyway! Regulators are chasing after Facebook, but here Facebook is, running to meet them.

Elsewhere in Libra, here is a Medium post titled “HyperDao to Hold Crowdfunding Campaign to Become Libra Validator Node,” and oh man is that a grim series of words. The idea is roughly that Libra will be run by a consortium of companies who invest at least $10 million and help administer the system, and $10 million isn’t that much money. It’s not the case that just anyone who puts in $10 million can get a seat at the table, but neither is it quite the case that it’s an invitation-only process where seats are given out at Mark Zuckerberg’s discretion. Libra wants to make claims to some of the openness and decentralization of cryptocurrency, so it doesn’t want membership to be arbitrary. So it published a list of criteria for membership in the association, and while the list is fuzzy and caveated enough to give them some wiggle room, there is always the risk of some weirdo showing up and saying “hey let me in I meet all the criteria” and embarrassing the whole project. If you can raise $10 million in a crowdfunding campaign, maybe that weirdo can be you.

Still elsewhere in Libra, here’s a good column from Max Read. (“In the global banking industry, Facebook has probably found the one group of corporations less liked and less trusted than itself.”) And here are some good questions about its monetary system from my Bloomberg Opinion colleague Tyler Cowen, along with some answers from Libra; one thing to say here is that these questions only make sense if you take Libra pretty maximally. If it’s just a weird payments function in Facebook then who cares whether, as Cowen asks, “some margins arise where there are fractional reserves.” But if it does become a major world currency then there probably ought to be, you know, a banking system to go with it.

Blockchain blockchain blockchain

One thing that advocates of blockchain for financial services tend to get excited about is that it allows for real-time settlement: When you agree on a trade of a stock, or a loan, instead of waiting two days or two weeks to get the actual stock or loan, you can get the thing instantly. Agreeing on the trade and exchanging the underlying items would happen simultaneously: The items would live on the blockchain, and the trades would occur on the blockchain, so the agreement would be the trade, with no messy complicated error-prone settlement process in between.

When you say it like this it sounds obviously good, and it's a big selling point for the blockchain. But when you talk to people who deal with settlement for a living, their reaction tends to be more like: Wait, that sounds terrible, why would you want that? One aspect of the current financial system, with its delayed settlement, is that you can trade stuff without owning it, or buy stuff without having the money for it yet. This sounds bad! It certainly creates some risks. But it also creates a flexibility that people have gotten used to, and that would be tough to lose.

Here is an elegant paper from Ken Monahan of Greenwich Associates titled “Steampunk Settlement: Deploying Futuristic Technology to Achieve an Anachronistic Result.” Monahan traces the history of settlement and clearing mechanisms back to 16th-century Venice, and notes that a major advantage of these mechanisms is that they allow for the extension of credit, which allows more trade to happen. Instantaneous settlement messes that up: “From the standpoint of secure, accessible books and records, DLT [distributed ledger technology, i.e. blockchain] represents an important step forward. From a funding perspective, it is a gigantic step backward.”

The advocates of DLT might counter that instantaneous settlement means that the benefits of multilateral settlement are unnecessary because the moment you have sold your shares, you have the cash instantaneously and you can redeploy it with another purchase elsewhere. This might be a valid argument in a marketplace composed entirely of end users, but, as anyone familiar with the U.S. equity market can tell you, it is by no means composed entirely of end users. In fact, the U.S. equity markets rely for a great deal of their liquidity on market makers, who, in turn, rely on the extension of credit within the clearing and settlement cycle and system. This is not typically well understood, but data from DTCC can shed some light on it.

Over a 28-day sample in the volatile months of November and December 2018, the average gross settlement balance was $326 billion, and the net was $32 billion, 90% of the funding needs were eliminated via netting— about what the Frankfurt exchange achieved in 1867. What’s more, thanks to the multilateral margining and risk management protocols of DTCC, these $32 billion in net settlements were secured with a mere $8.2 billion in commitments to the reserve fund from market participants. This is made possible by the risk management techniques utilized by NSCC and supplemented by reserves provided by NSCC itself, as well as additional advantages derived from its legal structure. Looked at another way, the benefits of netting and risk margining enabled $326 billion in transactions to be financed with $8 billion in capital, meaning each dollar of capital from market participants secured $40 worth of gross transactions.

This paper came out last week, when I was on vacation, but it’s arguably even more relevant after the Libra launch. As I suggested yesterday, and as Tyler Cowen implied in his questions, Libra doesn’t seem to come with much of a banking system. There’s no lending of Libra, no way to make a small supply of coins support a large amount of commerce. This is no problem at all as long as Libra is just a white paper, and it’s barely a problem as long as Libra is just a convenient way to make payments over Facebook, but if Libra’s long-term plan is to be the basis of a financial system that competes with the current dollar/euro/etc.-based system, then it will probably need to give some thought to how credit will work.

Things happen

How 7.4 Tons of Venezuela’s Gold Landed in Africa—and Vanished. CBS Is Planning Offer for Sister Company Viacom. The Hot New Thing in Funds Is Higher Fees and More Restrictions. Flood of debt instruments backed by property loans hits market. Major Banks to Weigh Environmental Impact in New Shipping Loans. Raised in a Log Cabin, Slack Chairman Is Now Worth $1.3 Billion. NBA All-Star Tony Parker Looks to Save Athletes From Blowing Their Fortunes. He Says He Invented Bitcoin and Is Suing Those Who Doubt Him. PG&E Reaches $1 Billion Settlement With Paradise, California Governments. Cerberus Hunts for Yield in Mongolia. 'They didn't look old enough': who filled a French art gallery with fakes?Humanity’s Eternal Quest for a Better Way of Peeling Garlic. I Ate Lasagna and Garfuccinos at the New Garfield-Themed Restaurant in Toronto.

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1. Well, on the one hand, big influential investors can sometimes buy securities of public companies directly from the companies at a much better price than ordinary public investors can. (See, for instance, Buffett’s deal with Occidental Petroleum Corp.) On the other hand, big influential investors who want to buy a lot of stock in one public company on the public market will often end up paying more for it, moving the price and/or paying a higher bid-ask spread, than random retail investors will pay for 100 shares. But for the most part, when Warren Buffett or whoever wants to buy stock, he buys the stock in the same market and pays the same sort of prices that you or I would pay.

2. In fact, one thing it focuses on is whether regular investors should be able to invest in private companies through pooled investing vehicles, which arguably solves some of my problem in the text: If you build a really good Public Venture Fund run by sophisticated professionals, and it raises lots of money from regular public investors, then it might get access to the first-class venture investments and do a good job for its public investors. The divide between “regular investor” and “sophisticated professional” is not as stark as you might think, just because for most regular investors the normal way to invest is to give your money to a sophisticated professional and let her manage it for you.

3. I mean, if you have a million dollars, you are more able to bear losses than someone with $100,000, but only for the same dollar amount of losses. If you have a million dollars and you invest it all in a Ponzi scheme, then you will lose more dollars than you could afford. And the current accredited-investor standard doesn’t come with any limitations on what percentage of your wealth you can invest.

4. Again, they don’t say how it would work, and it’s possible that they mean you’d self-certify *to the issuer* that you’re sophisticated. This is of course an invitation to fraud: The issuer hypes up a deal and then, buried in some form, makes you click a box saying “of course I want to be accredited.” My idea would involve *going to an SEC office in person*, filling out the form, bringing it to an SEC examiner, and having the examiner slap you hard across the face, or at least treat you to a withering stare and a healthy dose of sarcasm, before issuing your Certificate of Dumb Investment. This seems like a much stronger investor protection, though I suppose it would be more of an imposition on the SEC’s resources.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net