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Be Aware of Liquidity Risk as an Investor

Liquidity Risk is an important concept that continuously pops its ugly head up from time to time. It occurs when a party has urgency or an obligation to discharge an asset and it affects the market price for that asset by trying to sell it too quickly. Sometimes obligations cannot be met fully (even at distressed asset prices) and the party experiencing the liquidity risk event defaults, turning it into a crisis.

Understanding what liquidity risk is and how to mitigate it is of critical importance to generating long-term returns. Many fortunes have been lost in liquidity crises so understanding them is the first step to avoiding one of your own.

What is Liquidity Risk?

Liquidity risk is the failure of a person or business to meet its obligations. Whenever there are cash payments that need to be made or financial covenants/margin requirements that have to be maintained, liquidity risk is present. As we are talking about short-term obligations when they come due, the “current” liquidity is the term used but there is often long-term debt involved as well.

Liquidity risk occurs when companies or individuals overburden themselves with too much leverage. The term is often used in the banking industry when a liquidity crisis becomes a banking crisis. However, liquidity risk can be present in every industry as well as with individuals. Whenever the burden of meeting fixed payments on financial leverage, operating leverage, or a combination of both, prove to be too much and assets cannot to sold to meet obligations, the term liquidity risk could be used to describe the situation.

Where and When is Liquidity Risk Present?

Besides the leveraged situations already mentioned, liquidity risk is more likely in markets with certain characteristics. In markets where there are fewer investors and volume, there are less potential buyers if sales need to take place. As such, lower volume markets tend to be more prone to liquidity risk. Market prices in such shallow markets tend to move quickly and bid-ask spreads tend to be wider, as trades are less able to be absorbed.

In markets that are very one-sided, sales which go against the grain are better able to be absorbed. That being said, one-directional markets can have liquidity risks when the status quo opinion changes and the floodgates open in the other direction.

Liquidity Risk in the News

As I write this article in September 2021, the headlines across financial markets were recently rocked by the collapse of Archegos Capital Management. The firm was a family office for Bill Hwang that behaved very much like a hedge fund making concentrated bets with derivatives. Archegos Capital Management’s downfall was due to its aggressive use of total return swaps which left the firm exposed to cash settlements when the trades went the other direction.

Total return swaps are a type of derivative where stocks are not held directly but instead the total variable income and capital gains on the underlying security are exchanged for a fixed rate with the other party at a future point in time. Such swaps allow higher-value positions to be entered as money is not exchanged upfront but is instead settled over time. As with any leveraged trade, liquidity risks can be present when markets move in the opposite direction and covenants or settlements need to take place.

Managing Liquidity Risk with Asset Liability Management

Asset Liability Management (ALM) involves the matching of expected liabilities with similar timed assets. When we speak about timing and cash flow matching the word commonly used in finance is duration. There are positive and negative durations depending on if cash flows are coming in or leaving and the goal of ALM is to manage this balance. An effective ALM strategy can greatly reduce liquidity risk while also making sure that cash is put to work earning a return.

Third-Party Risk = Liquidity Risk

With liquidity risk, there is always the opposite side that is a loser when a party fails to pay their obligations. For this opposing party, the risk is referred to as third-party risk. For example, imagine going to cash in an option that you made a good deal of money on but unfortunately, the other party cannot payout. This other party’s failure to address their own liquidity risk has resulted in your third party risk. Modern centralized clearing houses and brokerages work to mitigate third-party risk through the practice of continuous position monitoring and margining requirements.

Liquidity Risk for the Retail Investor

Retail investors need to be cognizant of liquidity risk when using margin in their accounts or writing options contracts (remember the purchaser is exposed to third-party risk!). Oftentimes brokerages will have set weightings assigned to specific security types used to calculate your margin capacity. If asset levels fall below this, as can happen in market corrections, this can leave you struggling to sell assets at much lower prices.

A prudent measure if one is going to use margin is to always be able to withstand a large correction, say 50%, before being offside on their financial covenants or margin requirements. The same type of calculation can be used when writing naked options to limit your risk. Such prudent tactics can help lower the liquidity risk for retail investors if they choose to engage in more exotic investments.

Take Away for Investors on Liquidity Risk

Whenever there are cash payments that need to be made or financial covenants that have to be maintained, liquidity risk is present. The more shallow the market for the security being held, the quicker the price can move when dealing with unfavorable situations. Understanding what liquidity risk is and the situations in which it pops up, can help investors avoid some of the most unfavorable situations.