Liquidity Risk
Liquidity risk is the risk of loss from being unable to trade an asset quickly at a price near its fair value. It has two faces. Market (asset) liquidity risk is the cost of selling into a thin market: you receive less than the quoted mid because your order moves the price, an effect called price slippage or price impact. Funding liquidity risk is the risk of being unable to raise cash to meet obligations such as a margin call. The two reinforce each other: a forced seller facing a margin call (funding) dumps assets into a falling market (market), deepening the loss. This liquidity spiral turns a manageable shock into a fire sale.
Why it matters
There are two ways liquidity can hurt you. The first is selling the asset itself for less than it is worth because the market is too thin to absorb your order. The second is not having the cash to fund a position you must keep. The danger is that they feed on each other. A lender demands more collateral, you sell assets to raise it, your selling pushes prices down, your remaining collateral is worth less, the lender demands still more. Slippage is the gap between the price you see on screen and the price you actually get once your order has hit the market.
Formulas
Worked examples
Lehman Brothers, September 2008. The firm held large positions in illiquid mortgage assets financed by short-term repo. Why did funding and market liquidity risk combine to sink it?
As confidence fell, repo lenders demanded more collateral and shorter terms (funding liquidity risk). To raise cash, Lehman had to sell mortgage assets into a market where buyers had disappeared, realising fire-sale prices far below their marks (market liquidity risk, severe slippage). Each forced sale pushed prices lower, eroding the collateral value of what remained and triggering further margin calls. The self-reinforcing liquidity spiral exhausted the firm’s cash and it filed for bankruptcy. The marks on its books were never the cash it could actually realise.
The March 2020 "dash for cash". In the COVID shock, even US Treasuries, normally the most liquid market on earth, became hard to trade and their prices FELL when they usually rally in a crisis. Why, and what fixed it?
A global scramble for cash forced leveraged investors and foreign holders to sell whatever they could, and the safest, most liquid asset, Treasuries, was sold first to raise dollars (funding liquidity risk driving the selling). Dealers could not absorb the flood within their balance-sheet limits, so bid-ask spreads widened and market depth collapsed across the curve (market liquidity risk), with the worst dislocation around 9-24 March 2020. The Federal Reserve restored functioning by buying Treasuries on a vast scale, announcing purchases of at least 500 billion dollars in Treasuries plus 200 billion dollars in agency MBS, and at the peak buying roughly 75 billion dollars of Treasuries per day. The episode shows liquidity is a market-wide state that can vanish even in the deepest market, and that a central bank acting as buyer of last resort is what stops the spiral.
Common mistakes
- ✗Liquidity risk is the same as market risk. Market risk is loss from price moves at a fair, executable price. Liquidity risk is the extra loss from the price moving against you because you trade in size into a thin market.
- ✗Market and funding liquidity risk are unrelated. They reinforce each other. A funding shock (margin call) forces asset sales that depress prices, which tightens funding further, the liquidity spiral.
- ✗You can always exit at the quoted mid-price. The quoted mid is for a tiny trade. A large order walks the order book and executes at progressively worse prices, so realised slippage can be large.
- ✗Marking a position to the mid measures what you could sell it for. The mid ignores spread and price impact, so it overstates the cash a rapid liquidation would actually raise.
Revision bullets
- •Liquidity risk: loss from not trading fast at a fair price
- •Market (asset) liquidity risk = price slippage / impact when selling
- •Funding liquidity risk = inability to raise cash for obligations
- •The two reinforce each other in a liquidity spiral
- •Marking to the mid overstates realisable value in a fire sale
Quick check
A hedge fund meets a margin call by dumping assets, which drives prices down and triggers a further margin call. This self-reinforcing loop is best described as a
Price slippage refers to
Connected topics
Sources
- Brunnermeier, M. K., & Pedersen, L. H. "Market Liquidity and Funding Liquidity." Review of Financial Studies, 22(6), 2201–2238, 2009.Models the spiral by which funding and market liquidity reinforce each other in a crisis.
- Fleming, M., & Ruela, F. "Treasury Market Liquidity during the COVID-19 Crisis." Federal Reserve Bank of New York, Liberty Street Economics, April 2020.Documents the March 2020 "dash for cash" Treasury illiquidity and the Federal Reserve response.
- Jorion, FRM Handbook (2011)Jorion, P. Financial Risk Manager Handbook. 6th ed. GARP / Wiley, 2011.Distinguishes asset (market) liquidity risk from funding liquidity risk in the FRM curriculum.