Redemption engineering: honoring the token with the underlying

Graduate · enrolled learners

This lesson opens with The Third Avenue Focused Credit Fund, 2015.

What happened

The Third Avenue Focused Credit Fund was a US mutual fund that held illiquid, distressed corporate debt, bonds of troubled companies that could not be sold quickly without a fire sale, while offering investors daily redemption at the fund's stated value. In December 2015, facing redemptions it could not meet by selling those holdings without crushing losses, the fund did something almost unheard of: it suspended redemptions and moved its assets into a liquidating trust to be wound down over time, blocking investors from their money. It was the largest US mutual fund to halt redemptions since the 2008 crisis, and it shocked the market and drove the SEC to adopt new fund-liquidity rules. The failure was in the redemption engineering: the fund had promised daily redemption at a stated value over assets that could only be sold slowly and at a discount, so early redeemers were paid in full from what little could be sold while those who stayed were left holding the hardest-to-sell assets, and when that could no longer continue the only honest option was to stop and wind down. Redemption had been promised on terms the underlying could not honor, and honoring it for some had quietly harmed the rest.

The decision point

Redemption is not a database update; it is a promise that must be met by actually converting the underlying into money and paying the holder, so its terms, how fast, at what value, in what form, must fit the liquidity of the underlying, or honoring redemption for one holder harms the others. Third Avenue is the case: a fund promising daily redemption at a stated value over illiquid distressed debt paid early redeemers in full from the little it could sell, left those who stayed holding the least sellable assets, and finally had to suspend and wind down, the largest US fund to do so since 2008. Two failures compound here. First, the underlying could not be sold fast enough to meet redemptions, the mismatch of the prior lesson. Second, and the focus here, redeeming at a stated value that the illiquid assets could not actually fetch gave early redeemers a first-mover advantage: they got out at a value the remaining assets could not support, diluting everyone who stayed, so the redemption mechanism itself was unfair before it froze. For a tokenized asset the same engineering choices decide whether redemption is honest: redeeming a token must mean selling or delivering a fair share of the underlying, at a value the underlying can really fetch, on terms, notice periods, redemption limits, in-kind delivery, that keep one holder's exit from being paid out of another holder's share. So the decision is to engineer redemption so it is met from the underlying at a fair value and on terms the underlying's liquidity can honor, because redemption promised beyond that, redeeming at a stated value the assets cannot fetch, or faster than they can be sold, does not just risk a freeze like Third Avenue's; it quietly transfers value from the holders who stay to the ones who leave first, until the day it stops entirely.

Recorded loss

$789,000,000

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