Is the Future Direct Listing? IPO? ICO?

The NYSE petitioned the SEC to allow direct listing of stocks. The NASDAQ already allows this practice so it’s probably a fait accompli that the NYSE will be granted permission. Thanks to my friend Dan Ratner for bringing it to my attention.  If you don’t know Dan, he is the co-founder and CEO of Public Good.

Direct listings allow companies to have their shares trade publicly, without raising money as in a traditional initial public offering, and there aren’t restrictions on when insiders can sell shares.

Direct listing brings to fore a whole lot of issues confronting organized finance. I think the entire backbone of finance in every single financial silo is going to be disrupted in the next five to ten years.  I am investing in it.

One of the things that technology does when it takes control over an industry is that middlemen are eliminated. The distribution chain gets totally reworked and new technologically enabled middlemen take control. For a simple example, look at what Amazon ($AMZN) has done to retail.

I am all for direct listing but it has its own complications.  To be honest, I am for democratized access to markets with no tiers and full transparency.  Markets transmit data back to participants and supply and demand shifts.  Free unfettered markets are the most efficient allocators of resources known to man.  Electronic marketplaces make that happen faster.  However, there is a penalty if speed isn’t managed which is a topic for another blog post.

When we contemplated electronic trading at CME ($CME) back in the mid-nineties, we knew some of the things that might happen. If anyone is honest, we didn’t understand all the knock-on effects of the sea change.  Personally, I imagined a less tiered system.  That didn’t happen.

I also think it helps to understand why a company IPOs, and what the role of each player is.  IPOs allow the general public to invest in innovation.  They democratize capital and access.  Hence, the current public policy surrounding IPOs is way out of step with the way I feel about markets.  I think companies ought to go public sooner, not later in life.  It’s good for America.  It’s also good for companies to be publicly listed.

IPOs also allow early investors and employees who took the risk on the company to cash out.  There are limits to how much they can sell however which are called “lock-up periods”.  Cashing out funds new innovation since data has shown that successful early stage investors don’t take all their money off the table, but plow it into new ventures.  Successful venture funds aren’t one and done.  Employees that make money working for a startup generally go work for another startup or build one of their own-or they become investors.  IPOs help people build and create wealth.  That’s good for America.

IPOs are “lead” by an investment banker.  Bankers earn huge fees for leading the IPO.  I think the common perception is that the bankers don’t do a lot of work to earn their fees.  The reality is far different.  Not only do investment banks create the paperwork and structure backing up the IPO, but they do their own internal audits of the company to put their stamp of approval on it.  They organize what’s known as a “road show” where the company meets potential institutional investors who will hopefully be long-term holders of the stock.  It’s a glorified selling process but highly specialized.  Different banks have different relationships and networks that companies can tap into.  The right fit is important.

Bankers also probe the market to find an initial trading price.  This process isn’t formulaic math but more of a dark art.  They aren’t always right and usually IPOs are underpriced just a bit to let first-day investors make a little money.  Of course, first day returns aren’t necessarily predictive of the future.

Direct investing offers competition to investment bankers which will make them do their job better and cause their margins to compress.  It might also help out middle market investment bankers who are more competitive on fees.

Here is a great example how early stock trading isn’t predictive of the future.  Facebook looks like a juggernaut now but traded below the IPO price.

FB data by YCharts

This brings us to today.  What’s the future of IPOs in an era where we have massive technological change and things like direct listing?  If we assume public policy changes to incentivize more IPOs, I think we will see more direct listings with companies avoiding the full blown investment bank process.  In some cases, it’s possible to create the buzz and educate the investment community about the future of the company via social media.  Companies can hire law firms that specialize in getting the documentation together.  That saves companies money since they will pay less in fees.  It’s appealing because fees can be really high.

There is also another innovation on the near term horizon that everyone ought to pay attention to.   My friend William Mougayar has written extensively about this at his blog.  It’s the use of cryptocurrency to engage in what is called an ICO.  Initial Cryptocurrency Offering.  The initial effects of the ICO are that they are turning the venture capital model on its head.  I don’t think any federal agency has tried wrapping its head around the ICO.

When I first started thinking about Bitcoin, I thought that companies would issue their own namecoins instead of equity.  The balance sheet ramification is that assets increase in the form of cash, and liabilities increase in the form of current liabilities.  There is no classic equity.  The value of the company is determined by the value of the issued currency.  An existing company like Amazon or Target could issue their own cryptocurrency in place of equity.  That has strategic effects when it comes to marketing.  Arbitrage markets will exist between company cryptocurrencies.

One of the largest issues with IPOs isn’t what happens on Day 1.  It’s what happens on Day 2 and beyond.  Who will make a market in it? Who will be the long term holder?  Who will keep it liquid and trade it?

In the old days, specialists on the floor did that.  From the outside looking in, being a specialist was a license to steal. To commodity traders in Chicago, being a NYSE specialist looked like shooting fish in a barrel when it came to making money and assuming risk.  With the wave of electronic innovation, the old specialist system is gone.  Today, the market is driven by algorithmic and mathematical trading.

Here is how it works.

What happens on Day 2 with a market that is entirely driven by machines?

If we assume that more companies go public, machines should be able to scale support for those companies. In the old days, they’d wind up on the pink sheets.  “Pink sheets” are a publication that historically reported pricing for a group of corporate stocks not listed on a national exchange. Often referred to as over-the-counter (OTC) or penny stocks, pink sheet issues trade without SEC reporting requirements. Often, pink sheet stocks are modestly priced and trade with thin volumes.  Hopefully, with electronic trading, algos would make more liquid markets in pink sheet stocks and the market would be more efficient.

ICOs present a different problem but one that we have managed before. An ICO is a company currency.  Today, the FOREX market turns over trillions of dollars a day.  There is no reason that an ICO marketplace couldn’t accomplish the same efficiencies as the current FOREX marketplace.

There are plenty of instances where weird things happen in markets dominated by algorithmic trading.  Flashboys and other books have shown that.  At the same time, I don’t think that electronic versus human is the cause of anomalies in the marketplace.  In my opinion, it’s more about the structure of the marketplace and the way trades are matched than electronic versus human trading.  Markets aren’t “rigged”.

The key to all of this is light regulation and good market structure.  Structure markets based on principles of price/volume transparency, and equal access.  Don’t write rules that give any entity an artificial edge.  It’s also important for regulatory agencies to make it easier for new exchanges and clearinghouses to start.  That provides competition to existing platforms which are basically regulated monopolies today.

Embracing the free market is good for everyone.  It allocates resources better than any central planner.  Good companies will survive, and the poor ones will fail.  Good cryptocurrencies that are useful will prevail while the others will wither.  It’s not up to us to decide what’s fair or what should happen.   We just need to let the market do its thing and have faith that it’s correct.  Individuals will be richer for it.