The liquidity mismatch: instant token, illiquid asset

Graduate · enrolled learners

This lesson opens with The Woodford Equity Income Fund, 2019.

What happened

The Woodford Equity Income Fund was a large, popular UK investment fund run by a well-known manager, and it was open-ended and daily-dealing: investors could put money in and take it out on any business day at the fund's stated value. Over time, though, the fund came to hold a growing share of illiquid assets, small and unquoted companies whose shares could not be sold quickly without moving the price; the FCA's preliminary inquiries put its unlisted exposure at around 20 percent of its value in February 2019, against a 10 percent limit. After about two years of net outflows and poor returns, a very large redemption request from a single investor arrived, and the fund could not sell its illiquid holdings fast enough to pay, so it suspended redemptions on 3 June 2019, when only 8 percent of its investments could be sold within seven days, trapping around 3.6 billion pounds, and was ultimately wound down, with investors getting their money back slowly over years and taking losses. Nothing about the assets vanished; the failure was a mismatch, a promise of daily redemption written over assets that could not be liquidated daily. The fund had offered a liquidity its underlying could not honor, and when redeemers tried to use it, the promise and the assets could not both be true.

The decision point

A liquidity mismatch is the gap between how quickly an instrument promises holders their money and how quickly the assets behind it can actually be turned into money. When a fund, or a token, offers fast redemption or trading over assets that are slow to sell, the promise exceeds the underlying's real liquidity, and it holds only as long as few people use it; when many do, the promise cannot be met and the structure breaks, through a suspension, a gate, or a fire sale. Woodford is the case: a daily-dealing fund holding illiquid companies gated 3.6 billion pounds when redemptions outran what the holdings could raise. A tokenized real-world asset carries this risk in a sharpened form, because the token can be traded and redeemed instantly on-chain while the underlying, a building, a private loan, is deeply illiquid, so the token's liquidity can far exceed the asset's. So the decision when structuring a tokenized asset is to match its redemption and liquidity promises to the real liquidity of the underlying, because a token that offers instant liquidity over an illiquid asset is a liquidity mismatch on-chain, and Woodford is what a mismatch produces when holders try to use the liquidity that was promised but never really there.

Recorded loss

$4,600,000,000

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