The private credit market, valued at approximately $1.2 — $1.5 trillion in 2022 (projected to be $2.8 trillion by 2028), has relatively limited secondary trading activity, with 2022 volumes less than $20 billion. In contrast, the US corporate bond market, valued at around $11 trillion in 2022, boasted $28 billion of daily trading. Put differently, there is an annual secondary market turnover of 2% in private credit, and 96% in the US corporate bond market. This disparity can be attributed to multiple factors, including asymmetric information access and the lack of standardization in the private credit market.
Tokenization promises to reduce trading friction by increasing market access and lowering settlement costs. Additionally, the ability to trade and settle assets 24/7. Despite the rise in on-chain private debt issuance, the secondary market remains underdeveloped. Platforms like INX, tZero, and Bitfinex Securities provide market infrastructure, yet secondary trading of tokenized private debt is virtually non-existent.
Growth in the private credit market and asset tokenization are laying the foundation for future secondary market activity, where the impact of natively digital infrastructure should not be understated. Market electronification in investment grade and high yield corporate bonds has occurred steadily following the 2008 financial crisis. From 2019–2022, the share of high yield electronic trading grew substantially, from ~12% to 31%.
The Role of Credit Assessments in Enhancing Liquidity
While there are many factors affecting liquidity of assets, accurate pricing of the assets is a major factor in the ability to trade them effectively. Credit assessments, as a result, significantly impact debt market liquidity. Standardized credit ratings enhance investor confidence and guide market pricing. Active market participants are capable of providing liquidity by analyzing macroeconomic trends, sector-specific variables, and company-specific creditworthiness made available via credit ratings.
In an effort to support the tokenized debt markets, Credora recently announced the release of on-chain Credit Metrics. Over time, we believe on-chain Credit Metrics will prove to be critical infrastructure for the development of primary and secondary on-chain private credit markets, allowing market makers and smart contracts to easily consume crucial information to price and trade tokenized debt.
Potential for Growth in On-Chain Secondary Markets
On-chain markets, being digitally native, have a potential advantage in accelerating the development of private credit secondary markets. On top of efficient settlement processes, which are native to digital assets, the ingredients required for increasingly active secondary private debt markets include:
- Market Makers: Specialized quantitative trading firms can facilitate consistent pricing by borrowing underlying assets and providing inventory for price discovery.
- Available Comparables: Expanding data availability and credit rating information can help accurately price sector-specific debt.
- Active Market Interest: Active participation from legitimate buyers and sellers drives price discovery and creates a viable market. Expanding market access to various participants is crucial.
Pricing guidance is vital for secondary markets to evolve, especially in private credit where companies don’t disclose financial information regularly and lack internal controls mandated for publicly traded companies today. Credora addresses this issue by using transparent methodologies and distilling private information into Ratings Agency Equivalents (RAEs), allowing investors to benchmark opportunities against traditional debt markets. RAEs support the initial development of secondary markets in private credit by providing an issuance specific information source for market makers, which can be considered alongside yield curve shapes, debt tenor, current market credit spreads, and sector performance expectations.
Benefits of Secondary Market Liquidity
There are huge benefits to marginal liquidity in secondary markets:
- Portfolio Management: Investors can better mitigate risk by adjusting portfolios in response to changing market conditions.
- Flexibility: Investors can build portfolios by accessing issuances in the secondary market, reducing reliance on initial distributions.
- Transparency: Increased transparency boosts market confidence, attracting more capital.
- Valuation: Secondary market data ensures fair reporting and reduces risks associated with private and internal valuations.
- Benchmarking: Additional liquidity provides necessary data for effective pricing, benefiting future issuances.
It’s not only lenders who gain from a more liquid private debt market. The current illiquidity premium in private debt markets is estimated to be around 200 basis points (2%), costing borrowers an estimated $60bn every year in interest. Although this premium compensates investors for the risks associated with holding illiquid assets, it does so at the expense of private debt issuers. Active secondary markets would compress this premium, allowing issuers to access capital at increasingly competitive rates more in line with the underlying credit risk.
Future On-Chain Development
The development of secondary market liquidity promises to unlock new on-chain applications and efficiencies for market participants. For example, if there is widespread availability of Credit Metrics, it is possible for on-chain native portfolio construction, driven by programmatic, configurable, smart contract execution.
Additionally, the universe of eligible collateral is expected to expand, enhancing capital efficiency. Today, tokenized T-bills and other yield-generating stablecoins are eligible as collateral across multiple protocols and digital asset providers. Various Morpho Blue pools utilize tokenized T-bills as collateral, and FalconX recently announced trades executed with Superstate’s USTB as collateral. The ability to use other debt tokens as collateral could unlock significant utility for lenders, and as a result in a much larger and mature underlying debt market.
Conclusion
Credit assessments play a critical role in fostering liquidity in secondary private debt markets. By standardizing risk quantification and enhancing investor confidence, they enable more efficient pricing and market access.
As on-chain markets evolve, the potential for developing robust secondary markets increases, benefiting capital allocators through improved portfolio management, flexibility, and transparency. Furthermore, continued expansion of secondary market liquidity will unlock further capital efficiency, supporting more sophisticated liquidity management and broadening the set of eligible collateral.
Although we expect secondary private credit markets to evolve over a span of years, we believe that the current market landscape is an environment which can facilitate substantial growth. This is on the back of the increasing electronification in traditional markets, widespread interest in tokenization, and efforts to modernize credit access and efficiently distribute relevant credit market data on-chain.
In upcoming blogs, we’ll dive deeper into how on-chain credit assessments can foster applications that assist in portfolio management, and the use of loan tokens as collateral.
