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What is liquidity risk?

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Liquidity, or rather the lack of it, has been a hot topic of discussion and practical concern for the markets over the last few weeks of the coronavirus pandemic, but what exactly is liquidity risk and why does it exist? Dr. Andrew Street, Owner, Value Consultants Limited, explores the concept and what companies can do to manage it?

Liquidity risk (LR) is a broad term which covers a wide variety of risks across different types of financial companies and systems.

For a bank, LR is often seen as its inability to borrow money to fund its balance sheet, the costs of those funds and their availability being the key concerns.

For a fund manager, faced with demands for redemptions by investors in a time of market stress, the ability to sell assets such as bonds or equities at close to “fair value” is the major concern. The “flight to safety” creates a huge one-way flow out of risk assets in to the “cash” safe haven.

For a derivatives trader, a LR problem could mean increased costs in hedging positions due to stress in the underlying market, for example in delta hedging an option position.

Alternatively, as recent events have shown in the oil market, the LR can be a market squeeze caused by the physical nature of delivery for front month futures contracts in West Texas Intermediate (WTI) crude oil. If you are long a physical settled oil contract and don’t have storage to take delivery, you end up paying a very high price to get out of the obligation. Recently this hit $42 a barrel, NOT to buy, but to SELL a barrel of the US crude delivered at Oklahoma’s land locked Cushing complex.

To progress, we need to understand the specifics of LR in more detail, its exact nature, measurement, and most importantly, its management. As with any other financial risk, it shares some common characteristics:

  • Risk is forward looking, we are dealing with events in the future, a minute, a day or a year.
  • Risk is about the probability of events, so we are dealing with likelihood or frequency of events.
  • Risk is about the impact or severity of those events – so for example, high frequency, high impact negative outcome events are in general unacceptable for any real world, long term business enterprise. It is part of management’s job to engineer out such circumstances or provide very strong mitigation in the form of capital or insurance.

In many ways LR has characteristics which transcend other risks like market and credit risk due to its close interplay with other market participants and its immediacy. You cannot sell, for example, if there is no one to buy. You cannot borrow, if there is no one to lend. If your need for cash (or “liquidity”) is immediate and it cannot be “sensibly” achieved, this nearly always leads to an event of default, bankruptcy, and litigation by angry customers and counterparties.

Let’s examine the nature of markets and specifically their liquidity a bit more detail. In order to transact the sale of a risky asset or to borrow funds, we need a counterparty who is prepared to take the other side of the transaction. Logic dictates that in to order transact, the counterparty must expect that the transaction will have a positive expected pay-off for them, i.e. there must be a positive risk premium in the transaction.

For example, a market maker in normal market conditions will bid for a risky asset at below the perceived fair value, with the expectation that the position can then be sold on or hedged at a price level above this purchase price, ensuring a positive return on the risk transaction. As markets become more volatile (uncertain) and the balance of willing buyers and sellers in a market shifts (say due to a fire sale out of high yield bonds) the remaining market makers will widen their bid-offer spread and reduce their trading size to ensure a positive risk premium for the trade. More volatility and less liquid markets mean necessarily higher LR premiums to make the purchase of risk assets or the lending of money economically viable. In an extreme case this could mean that the “sensible” bid for the risk asset is zero. It is also noteworthy that there has been a huge reduction of bank risk capital committed to the securities market making business over the last decade due to regulatory changes such as Basel III. Markets have therefore progressively become less liquid, exacerbated in times of stress.

If we think about markets further, we know that in order to have a functioning and balanced market we need three distinct participants:

  • Speculators
  • Hedgers
  • Arbitrageurs

Typically, market makers are in the third category and hence their focus is on being adequately compensated for taking on LR.

Some markets have an additional and very important participant, the central bank. Increasingly these state entities have intervened in markets to provide a moderating and controlling influence, typically to manipulate prices and rates and provide stabilisation in times of market turmoil. These events are triggered by major economic shocks like the Global Financial Crisis (2008) or the current COVID-19 pandemic (2020) and the resulting economic crisis. Central banks essentially have unlimited financial fire power in their own currencies and can be the “buyer or lender” of last resort. They are frequently price insensitive and will use their monetary clout to hold prices or rates to desired policy ranges. As we seen recently this activity has extended beyond government bond markets and into corporate high yield bonds and even equity and oil. The actions of the central banks in these situations creates a tidal wave of price insensitive liquidity which transcends normal markets, effectively rending the normal price discovery mechanism and transfer pricing ineffective and inaccurate at best. In the short term this in effect “tranquilises” the market and reduces volatility. Quite what long-term effects this activity will have, no one is really sure, it may in fact just defer rather than cure the underlying problem. The problem may actually stem from an over leveraged and indebted financial system which has become overly reliant on central banks in a positive feedback loop, which may well end badly.

So, what can we do about LR?

As with all risk essentially there are three steps - IQM:

  • Identification of the source and types of liquidity risk present in the business
  • Quantification of risk in terms of potential frequency and impact of the possible LR events
  • Management of the LR using tools and techniques such as liquidity buffers, committed credit lines, VIX futures hedges and more advanced techniques like using 30-day rolling stress tests. The latter, for example, is the basis of the Basel III LCR rule for Banks.

Recently we have seen LR effects in the government bonds markets when in mid-March the lows of the stock market were prompted by a flight to quality in response to the COVID-19 lock down. We saw the sale of equities and the purchase of treasuries, the later naturally rallied in price at first. But then redemption requests to mutual funds by investors prompted the sale of treasuries to provide the cash for redemptions. This was largely because equity holdings were hard to sell at reasonable price levels and the government bonds had rallied. This caused the classic inflection signal (“shock effect”) in treasuries which rose in price sharply, then fell very rapidly below the starting price to the return to approximately the same pre-shock price level over the course of a few days. A similar effect was also seen in gold (bullion), another classic hedge asset used in portfolio risk management. For some, their hedges effectively fell in price rather than rallied, due to LR effects.

As I referred to in my introduction, there has also been the well-publicised LR behaviour in the front month WTI (Oil) futures contract. This exchange traded derivative is used by funds to track oil prices as a commodity investment, the ETF “USO” being the most widely know example. This futures contract settles through physical delivery of oil to a delivery point at Cushing, Oklahoma. The investment funds are naturally long (own) this contract which they must roll into the next month before expiry or else take physical delivery. The latter would mean renting storage tanks in Cushing. The global economic slowdown and the glut of world oil meant that storage was already full or had a very high rental cost, this in turn led to the distortion in the futures calendar roll which effectively priced spot oil at MINUS $42 per barrel. This cost is in effect the liquidity premium at that time to transition from “paper” oil to the real physical crude. This price distortion created substantial losses to the ETF “USO”, meaning it failed to properly track its underlying index.

Liquidity risks are ubiquitous and identifying, measuring, and managing them is an essential core process for any financial institution.


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