Understanding Liquidity Risk

Before the global financial crisis (GFC), liquidity risk was not on everybody's radar. Financial models routinely omitted liquidity risk. But the GFC prompted a renewal to understand liquidity risk.1 One reason was a consensus that the crisis included a run on the non-depository, shadow banking system—providers of short-term financing, notably in the repo market—systematically withdrew liquidity. They did this indirectly but undeniably by increasing collateral haircuts.

After the GFC, all major financial institutions and governments are acutely aware of the risk that liquidity withdrawal can be a nasty accomplice in transmitting shocks through the system—or even exacerbating contagion.

What Is Liquidity Risk?

Liquidity is a term used to refer to how easily an asset or security can be bought or sold in the market. It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.

Funding Liquidity Risk

Funding or cash flow liquidity risk is the chief concern of a corporate treasurer who asks whether the firm can fund its liabilities. A classic indicator of funding liquidity risk is the current ratio (current assets/current liabilities) or, for that matter, the quick ratio. A line of credit would be a classic mitigant.

Market Liquidity Risk

Market or asset liquidity risk is asset illiquidity. This is the inability to easily exit a position. For example, we may own real estate but, owing to bad market conditions, it can only be sold imminently at a fire sale price. The asset surely has value, but as buyers have temporarily evaporated, the value cannot be realized.

Consider its virtual opposite, a U.S. Treasury bond. True, a U.S. Treasury bond is considered almost risk-free as few imagine the U.S. government will default. But additionally, this bond has extremely low liquidity risk. Its owner can easily exit the position at the prevailing market price.2 Small positions in S&P 500 stocks are similarly liquid. They can be quickly exited at the market price. But positions in many other asset classes, especially in alternative assets, cannot be exited with ease. In fact, we might even define alternative assets as those with high liquidity risk.

Understanding Liquidity Risk

Market liquidity risk can be a function of the following:

·         The market microstructure. Exchanges such as commodity futures are typically deep markets, but many over-the-counter (OTC) markets are thin.

·         Asset type. Simple assets are more liquid than complex assets. For example, in the crisis, CDOs-squared—CDO2 are structured notes collateralized by CDO tranches—became especially illiquid due to their complexity.

·         Substitution. If a position can be easily replaced with another instrument, the substitution costs are low and the liquidity tends to be higher.

·         Time horizon. If the seller has urgency, this tends to exacerbate the liquidity risk. If a seller is patient, then liquidity risk is less of a threat.