February 1814 was the last time London had an ice fair. The river Thames froze over, and a four day party ensued. There was ice skating, gin drinking, and even roasted oxen under Blackfriars Bridge.
This may seem like a fairy-tale to modern Londoners. But between 1309 and 1814, the Thames reportedly froze over an extraordinary 23 times. On five occasions, the ice was thick enough to hold a fair.
The ice fair was organised by the watermen and the lightermen, who were involved in the transportation of goods along the river.
When the weather cooled, their livelihoods were at risk. If the river froze, they wouldnât be able to earn an income. They had a very early version of Liquidity Risk. If the water stopped flowing, they could no longer guarantee that they would be able to sell their services.
In response, they organised the fair and charged for access to the ice, thus managing to continue earning an income while their usual business was… on ice.
I canât quite imagine Neil Woodford pursuing the same solution. From celebrated fund manager, darling of Hargreaves Lansdown and the Financial Times, to ice rink receptionist.
Heâd probably at least get the job at the Somerset House rink. Tickets are non-refundable, for one. And itâs so crowded in there it can be pretty tough to extricate yourself after a bone-cracking slip on the ice.
(Neil Woodford runs a fund which recently had to block investors from taking their money out, because he had invested in too many illiquid assets, and couldnât sell them fast enough.)
The parallels are perhaps a little forced.
But the point Iâm trying to make is that assumptions are dangerous. Something which seems to be fixed and reliable at first glance, may well not be.
We assume that the Thames will continue to flow as a liquid indefinitely. Our experience from our own lives suggests to think otherwise would be madness.
But just because something is very rare, it doesnât mean it will never happen.
Nassim Taleb, author of Black Swan and Fooled By Randomness, is at the forefront of a movement which tries to show that humans tend to underestimate the likelihood of very unlikely events.
Thatâs why I gave you that stat about the Thames freezing over 23 times â roughly once every thirty years â between 1309 and 1814.
Is liquidity in financial markets of the same nature? The assumption of liquidity is nearly unanimous. Or at least it was, until May.
Neil Woodfordâs famous Income Fund was âgatedâ, which means he barred investors from taking their money out. It was a major news story.
His investments in small, unlisted companies were so illiquid that he couldnât sell his positions fast enough to keep up with investors pulling their money out of the fund.
I wouldnât say that it has sent shockwaves through the financial world, but a ripple of unease has certainly filtered outward.
Last year, GAM (Global Asset Management), an investment house based in Switzerland, had to gate its Absolute Return Bond Funds following mass outflows.
And itâs happening again, at H20 Asset Management. The Financial Times pointed out that swathes of its illiquid bond holdings had links to a flamboyant entrepreneur (Lars WIndhorst) with a history of legal troubles. Now, the incredibly ironically named H20 is suffering from mass outflows and crashing investor sentiment. The fear is that illiquidity will force another gating of a huge fund.
Could one you invest in be next?
Whoâd be a financial regulator?
Three major incidents of illiquidity have forced fund managers to pull up the drawbridge, keeping investors locked in.
What must the regulator be thinking? With its âGlorious Defender of Retail Investorsâ superhero suit on, it must be thinking it has to do something. Or be seen to be doing something.
Just last week, Mark Carney, governor of the Bank of England, came out and said that funds which invest in illiquid assets but allow investors to instantly access their money are âbuilt on a lieâ.
He added that if nothing is done, the difference between the underlying liquidity of the assets and the liquidity of the fund risked becoming a systemic problem. In other words, these funds are not nearly as liquid as they pretend to be, and that could be a massive issue for the markets, and investors.
I think this could be where the real danger lies.
Letâs imagine that the regulator woke up, read Mark Carneyâs comments, and thought âCrikey! Better do something about this or Iâll get blamed if it happens again!â
So, the regulator announces itâs halving the maximum allowance of illiquid investments allowed in a fund, from 10% to 5%. Perfect â with half the illiquid assets, the fund will be much more liquid and retail investors will have much lower exposure to liquidity risk.
However, all funds investing in those assets will have to sell off half of their illiquid holdings. In unison. But thatâs simply not possible â the definition of illiquid assets is that you canât sell them quickly and easily.
What we have learned is that this is a slow and difficult process. Itâs slow and difficult when just one fund is selling. If hundreds of funds are all simultaneously trying to halve their exposure to illiquid assets, then sellers will overwhelm the market. With no buyers, the funds wonât be able to sell their holdings at all, and will be frozen in place. Forced to sell, but with no one to sell to.
In such a case, the liquidity of these assets will become as much of a myth as the liquidity in the Thames.
If the regulator decides to act to protect investors, it could end up doing much more harm than good.
Kit Winder
Investment Research Analyst, Southbank Investment Research
Category: Market updates