When I think about the evolution of the market place for debt and equity, I am reminded of the importance of the primary market. At some point in our society, ownership rights were established and equity was born. Capitalism led citizens to invest money in small businesses (primary market) for CapEx and working capital. We have always had a resale market (secondary market) where buyers purchase businesses and assets from others, but only in our recent history has the secondary market and derivative market become the focus for investors.
From an overly simplistic view, there are two sides of the market, the capital providers and the capital takers. Our transition to the secondary market has caused those with capital to purchase securities that already exist. No money is injected into the business. No buildings are constructed. No workers are hired. No inventory in purchased. Derivatives are even worse. Instead of providing liquidity to existing business owners by transferring ownership, investors make side bets on the performance of a given company. Don’t get me wrong, I am the first to support free markets, but derivatives do not add value for the underlying assets.
Example: An investor has $100MM cash. He thinks oil prices are headed upward over the next five years. The investor of yesterday would purchase a drilling business, build rigs, construct a refinery, build a distribution network. The investor of today purchases call options on an oil ETF with a financial institution taking the other side of the trade. Perhaps the investor has maximized his return, but the business investment never saw the capital.
Back to Primary Markets – OK, so we have plenty of primary market activity with IPO’s, DCM activity, and Private Equity Investments, but I do consider this question:
Has the shift to secondary markets and derivative investing, reduced our investment in physical assets and new businesses? Billions of dollars of the world’s investable capital are invested in side bets, but could be invested in assets that provide jobs and support economies. Is there a fundamental flaw in the system?
*Caveat – I’ll admit, there is value in a secondary market. It provides liquidity for existing investors and provides market values to benchmark transactions, but it should exist for the sole reason of supporting businesses in the capital raising process.
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Some excellent points. Here are some counterpoints that come to mind which may or may not be valid: Companies only do IPOs, secondary offerings and debt offerings every once in a while (depending on the company). When you have this giant pool of money trying to chase investments, not all of it can be absorbed by primary markets. Institutional investors are only willing to give Facebook $15 billion because there is a secondary market that is willing to buy it from them.
With respect to derivatives, it's true that betting on CDS futures doesn't entail investment in tangible things that contribute to economic growth. That said, the fact that they can be used to hedge is certainly a huge benefit. If used right (and this is a big if), they can reduce systemic risk. But your point is well taken. Is it a good idea to have that much money tied up in side bets that are not tied to real economic investment?
Here's one thought that just popped into my head; prior to the originate/distribute/securitize model of lending, we had commercial banks which took in deposits, lent them out, and held the loans until maturity. This type of scenario is akin to your ideal, where all investment is directly used for new projects, etc. Once securitization started, people started packaging up the loans and reselling them in secondary markets. Now, if I bought an CDO, is that directly lending money to someone? No, not directly. But the advent of securitization (secondary markets) led to a huge boom in lending (primary markets) to institutions and individuals. So, the advent of secondary markets led to a lot more activity in primary markets. So perhaps, in that way, it's justified to have that much money tied up in secondary markets?
uh...so you deleted your old post and reposted it?
Absolutely. IMO it is largely driven by the use of cash settlement. That is the CDS seller and the CDS buyer can agree on the value of the defaulted bond (i.e. its recovery rate), rather then physical settlement, which is when the CDS buyer gives the bond to the CDS seller and receives a payment in exchange. As a result of cash settlement there has been an explosion of CDS indexes because debt obligations can be included in a number of different indexes (misallocation of capital). Consequently, the notional value of the CDS contracts referenced to a firm often exceeds the value of its debt.
You see physical settlement is not desirable for CDS buyers with pure derivative positions since they would need to source the bond in the open market. When there are more contracts than bonds outstanding, a defaulted bond can be obtained only in a roundabout way: A bond would be handed over upon default to a CDS seller who would then sell the bond, at which point another CDS buyer could buy the bond to use it in physical settlement of his contract. This desire to get one’s hands on the scarce bonds is likely to drive up the price artificially beyond its expected recovery value, reducing the value of the CDS contract to its buyers.
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