The Hidden Dangers Behind the New American “Exchanges”

A dangerous group of American exchanges is attracting money from thousands of investors.

These exchanges are nothing like the Dow Jones Industrial, Nasdaq, or S&P 500. You can’t buy well-known companies like GE or McDonald’s on them. Nor can you buy the small high-tech companies found on the Nasdaq. But they claim to give you a chance to profit from historically “off limits” companies – companies that only professional investors (and extremely wealthy individuals) were once allowed to invest in. Now, if you want, you can invest right alongside them.

Of course, the hedge funds and investment banks are investing with other people’s money. You’d be investing with your own hard-earned cash.

No matter. Many ordinary investors (like you and me) can’t resist. They’re buying hundreds of millions of shares of American companies on these exchanges, hoping to grab the promised fast profits that were never before available to them.

You want to invest in collateralized debt obligations? Now you can.

Are auction rate securities more your cup of tea? No problem. They’re just one click away.

You can even buy shares of privately owned companies like Twitter, Facebook, and Zynga (the developer of online social games).

But I’d think twice if I were you.

You’d be investing in an exciting story…


The hype is deafening.

The thing is, though, you’d know practically nothing about the companies you’d be investing in.

You think you know Facebook because you have a Facebook page? Or because your spouse or kid does? Think again.

Like companies from Libya, Ghana, Bolivia, Russia, and China, Facebook has no interest in sharing information with you.

Listen to this: “We don’t typically share information about our financial performance.”

That’s a Facebook spokesman simply telling you the way it is. But he doesn’t stop there. He even tells you that it’s no use trying to figure Facebook out. And that those who do just end up playing a big guessing game: “While there are external attempts to forecast our revenue or value the company, many of them involve a great deal of speculation.”

It doesn’t get much clearer than that, does it?

Yet, investors are still buying into Facebook in alarmingly increasing numbers. And you can thank online private exchanges like SecondMarket, SharePost, and GreenCrest.

In 2009, Facebook was responsible for 48% of the rise in SecondMarket and 40% of the rise in SharePost. In the most recent month we have data for, December, purchases of Facebook shares rose 25% in SecondMarket and 12% in SharePost.

These exchanges are fairly new. They’ve been around fewer than five years. And shares in private companies aren’t the only thing they sell. SecondMarket, for example, as a registered broker/dealer, makes 90% of its money selling other kinds of illiquid stuff.

Keep in mind that the number of private company shares trading on these exchanges is tiny compared to the number of shares traded on our major exchanges. But it’s growing fast. In 2009, $2.4 billion worth of private shares were sold. In 2010, $4.9 billion were sold. (To give you some perspective, the market value of the S&P 500 in 2010 was over $11 trillion.)

Listen, Facebook is doing nothing wrong, illegal, or unethical. Like Twitter and Groupon and LinkedIn (and other private companies), they are simply taking advantage of one of the privileges of their “privately held” status.

They – not the SEC or the New York Stock Exchange – get to decide what information to disclose.

But are these really the kind of companies you should be excited about? Companies you should be putting your hard-earned money in?

Absolutely not.

Four Reasons to Stay Away

Just because the hedge funds are willing to gamble on Facebook and Twitter, that doesn’t mean you should. So before you go rushing off to buy shares in these companies, you need to come to grips with these issues…

1. The biggest, as I said, is the dearth of information. You can toss information-based investing out the window. These are adrenalin-driven, “buy at any price” markets. You’d be making the ultimate “caveat emptor” (buyer beware) investments.

2. You’d be buying thinly traded, privately held shares. Finalizing a buy or sell transaction could take from several days to several weeks. And heaven forbid you get caught at the selling end of a high-flying stock that has lost its wings.

3. Just a couple of years ago, investing in a company pre-IPO (Initial Public Offering) would have meant that you were investing with the smart money before the herd rushed in. But there’s nothing about Facebook that shouts “early to the party.” It has 2.5 billion shares outstanding. And because of the feeding frenzy surrounding the company, those shares are now worth about $70 billion.

4. You can’t short these shares. You can’t place a put on them (betting that they will go down). Meanwhile, you have an increasing number of investors chasing a very small amount of equity. The result? A one-way, closed-loop squeeze to higher ground. The euphoria builds. The shares go higher. And the higher prices raise the level of excitement even more.

In other words, you’re looking at a guaranteed bubble in the making. Eventually, it’s all going to come crashing down to earth. You don’t want to be part of this.

Nor is this healthy for the private companies being traded. You don’t think Facebook understands this? Last April, it forbade its employees to cash out their stock holdings.

The online private exchanges also put at risk the privately held status of these companies. The SEC limits the number of their owners to 500. Beyond that, a company must disclose more financial data. And we already know how Facebook feels about that.

These exchanges are non-transparent, bubble-making machines that run on pure adrenalin. They’re perfect for gamblers who love excitement and don’t mind losing wads of cash. For everybody else, they’re a terrible idea.

You’ve been warned.