Understanding Liquidity Risk

The global financial crisis (GFC) of 2008 brought renewed focus on the importance of understanding liquidity risk, which refers to the risk that a financial institution or market will be unable to meet its financial obligations when they come due.

Prior to the GFC, liquidity risk was not widely considered in financial models. However, during the crisis, it became clear that the shadow banking system, which provides short-term financing, played a role in transmitting shocks through the financial system by withdrawing liquidity.

As a result, governments and financial institutions are now much more aware of the potential for liquidity withdrawal to exacerbate contagion during times of financial stress.

What is liquidity risk?

Liquidity refers to the ease with which an asset or security can be converted to cash in the market. It is an important concept in finance, and there are two types of liquidity risk: funding liquidity or cash flow risk, and market liquidity risk, also known as asset/product risk.

Understanding these risks is critical for financial institutions and investors to manage their exposure and make informed investment decisions.

Funding Liquidity Risk

Funding or cash flow liquidity risk refers to the risk that a company will be unable to meet its financial obligations as they come due. Corporate treasurers are particularly concerned with this type of risk, and it can be measured using indicators like the current ratio (current assets divided by current liabilities) or the quick ratio. A line of credit is often used as a tool to mitigate this risk.

Market Liquidity Risk

Market or asset liquidity risk refers to the risk that an asset cannot be easily sold in the market, often due to a lack of buyers or unfavorable market conditions. For example, if a person owns real estate that they cannot sell due to a slowdown in the market, they may be unable to realize the full value of the asset.

This is in contrast to an asset like a U.S. Treasury bond, which is considered almost risk-free and has extremely low liquidity risk. Its owner can easily sell it at the prevailing market price. Similarly, small positions in S&P 500 stocks are highly liquid, as they can be quickly sold at the market price.

However, positions in many other asset classes, particularly alternative assets, may not be as easy to sell due to high liquidity risk. In fact, alternative assets are often defined as those with high liquidity risk.

It is important for investors to consider liquidity risk when making investment decisions, as it can impact their ability to exit a position when needed.

Understanding liquidity risk

Market liquidity risk refers to the risk that an asset cannot be easily sold in the market due to a lack of buyers or unfavorable market conditions. There are several factors that can impact market liquidity risk, including the market microstructure, the type of asset being traded, the availability of substitute assets, and the seller's time horizon.

For example, exchanges like commodity futures tend to be deep markets with high liquidity, while over-the-counter (OTC) markets may be thinner and less liquid. Simple assets are generally more liquid than complex assets, and if a position can be easily replaced with another instrument, the substitution costs are lower and the liquidity tends to be higher.

Additionally, if a seller has a sense of urgency, this can exacerbate liquidity risk, while a patient seller may face less risk. Ultimately, market liquidity risk is often a problem that can be solved with more time.

Measures of market liquidity risk

There are multiple perspectives on market liquidity, including the bid-ask spread, depth, and resiliency. The bid-ask spread, also known as the width, refers to the difference between the price at which buyers are willing to buy an asset and the price at which sellers are willing to sell it.

A tight bid-ask spread, or a narrow difference between these prices, is generally seen as a sign of a more liquid market. Depth refers to the ability of the market to absorb the sale or exit of a position without significantly impacting the price.

For example, the sale of a large block of shares in a small capitalization company is likely to have a bigger impact on the price than the sale of a small number of shares in a large, well-established company. Finally, resiliency refers to the market's ability to recover from temporary price deviations.

To summarize, there are three main perspectives on market liquidity: the bid-ask spread, position size, and resiliency.

The bid-ask spread measures liquidity in the price dimension and is a feature of the market, not the seller or their position.

Financial models that incorporate the bid-ask spread adjust for exogenous liquidity and are known as exogenous liquidity models. Position size, or the relative size of the seller's position to the market, is a feature of the seller and is used to measure liquidity in the quantity dimension in endogenous liquidity models. Resiliency measures liquidity in the time dimension, but models that use this measure are currently rare.

At the highest level of market liquidity, the owner of a small position relative to a deep market would be able to easily sell their asset with a tight bid-ask spread and without significantly affecting the market price. The market itself would also be highly resilient, meaning that it would be able to bounce back from temporary price deviations.

Volume

Trading volume is a measure of liquidity that is often used by investors and analysts to gauge the activity in a financial market. However, it is now considered to be a flawed indicator, as high trading volume does not necessarily equate to high liquidity.

This was demonstrated during the Flash Crash of 2010, when sell algorithms fed orders into the system faster than they could be executed, leading to a spike in volume but a lack of actual trades. According to the Securities and Exchange Commission (SEC), "especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity."

This highlights the importance of considering multiple factors when evaluating market liquidity, rather than relying on a single metric such as trading volume.

Summary

Liquidity risk is the risk that an asset or security cannot be easily bought or sold in the market, which can have negative consequences for the value of the asset or security. There are two types of liquidity risk: funding liquidity risk, which refers to the risk that a company or organization will be unable to meet its financial obligations as they come due, and market liquidity risk, which refers to the risk that an asset cannot be easily sold in the market.

Market liquidity risk can be further divided into endogenous liquidity risk, which is a feature of the seller and occurs when the seller's position is large relative to the market, and exogenous liquidity risk, which is a characteristic of the market and occurs when the marketplace has withdrawn buyers.

A common way to include market liquidity risk in financial risk models is to adjust the measure by adding or subtracting one-half the bid-ask spread, which is the difference between the price at which buyers are willing to buy an asset and the price at which sellers are willing to sell it.