Mark Carney’s A Few Weeks Behind Us- Open Ended Funds In Illiquid Investments Are Dangerous

Mark Carney, the Governor of the Bank of England, tells us all that open ended funds with high levels of illiquid investments are a danger and a problem. Actually, he goes further:

Mark Carney launched an attack on “open-ended” investment funds with high levels of illiquid holdings, warning they are “built on a lie” and could pose a “systemic” threat following the suspension of Neil Woodford’s flagship fund. The Governor of the Bank of England told the Treasury select committee on Wednesday that the rise of such funds had created “an expectation from individuals that it is not that different from having money in a bank”. “These funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid,” he told MPs.

The amusement is that of course he’s right, but then he’s right about banking too. Bank loans out are fundamentally more illiquid than bank deposits going into them. Which is why we can have bank runs and why we’ve a central bank to finance banks through a bank run.

We all know about fractional reserve banking. The bank doesn’t have our deposits down in the basement, they’re out in the loans and mortgages. If we all turn up and demand our money back today then the bank doesn’t have it – we get a bank run. There we’ve a central bank willing to supply the missing liquidity. Funds don’t have that as LTCM showed those years ago. The underlying reality here being that whatever the promises of liquidity – ease of getting out of the fund – promised by the promoters, in the end they can only be as liquid as the market in which they’re investing.

Quite so, as we’ve been saying – even if elsewhere:

We can’t cash in our investment in the fund because the fund can’t sell the underlying investment fast enough to be able to repay us. We’ve a liquidity mismatch and there’s no real solution to it. In banking, of course the central bank provides the liquidity to stop bank runs. No one does – and no one should – for investment funds.

The answer is quite simple. Open ended funds which wish to be in illiquid investments simply have to impose a certain illiquidity upon their own investors. There we are, job done.

Which is, of course, what sensible such funds already do – near all VC funds insist upon a lock up period. Simples.

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Quentin Vole
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Quentin Vole

Open ended funds which wish to be in illiquid investments simply have to impose a certain illiquidity upon their own investors.
Which they all do, and is why they’re not banks – you can’t necessarily get your money back on demand. Unsophisticated investors should have this explained to them before they invest – sophisticated ones (like Kent County Council, FFS) really, really ought to know.

Matt Ryan
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Matt Ryan

Holding money in high interest bearing accounts with Icelandic banks showed how sophisticated the public sector is.

Quentin Vole
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Quentin Vole

Yep, I should really have put in some scare quotes :). A very good friend was investment director for a large insurer. He was asked by the CEO what he did to maximise the yield on overnight money (many millions). “Nothing,” was his reply “I could get a few more basis points by using an Icelandic or Indian bank, and then one day we won’t be able to get it back. If that only happens once every century, we’d still be massively out of pocket.” And then a couple of years later, Kaupþing went tits up …

Matt
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Matt

Running these funds as ETFs seems to be the logical solution: you can sell your investment to another party at whatever the other party is willing to pay for it. The fund manager doesn’t have to liquidate the underlying assets in order to do so.