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. After 1.1 billion dollars of net outflows in 2015, more than 145 percent of its remaining net assets of about 789 million dollars, its board decided on 9 December 2015 that further sales to meet redemptions would have to be made at prices that would unfairly disadvantage the remaining shareholders, and adopted a plan of liquidation, first moving its assets into a liquidating trust. After the SEC staff raised concerns, the fund reversed that step and on 16 December obtained an SEC order to suspend redemptions while it liquidated, a rare step because US mutual funds may not ordinarily delay paying a redemption for more than seven days. The SEC was then already working on its fund-liquidity rule, and its October 2016 adopting release cites the case. 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 redeemers were paid from what could be sold while the portfolio left behind grew more concentrated and harder to sell, and when that could no longer continue the only honest option was to stop and wind down; shareholders recovered approximately 85 percent of the fund's value at the start of the liquidation, with the final payment in June 2018. 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 redeemers from what it could sell, left those who stayed holding a more concentrated, less sellable portfolio, and finally had to suspend and wind down under an SEC order. 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

Orientation and Year One are open: anyone can read them without an account. From Year Two onward the lessons are for enrolled learners, because progress through the later years only means anything if it is tracked against a record.

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