In the context of traded markets, liquidity risk is the risk of being unable to buy or sell assets in a given size over a given period without adversely affecting the price of the asset. The risk will be high if, for example, a large trade is being executed over a short period of time in an insufficiently liquid market.
Some market participants have argued liquidity risk has become worse after the global financial crisis due to bank capital constraints, with dealers facing higher costs to hold inventories of securities and warehouse risk.
An additional concern is that investor crowding into similar trades can lead to mismatches between willing buyers and sellers of certain assets in periods of stress, leading to diminished liquidity and putting further pressure on asset prices.
In the context of funding, liquidity risk refers to the ability of institutions to fund liabilities as they fall due without incurring losses through being forced to sell less-liquid assets quickly.
An area of focus for post-crisis regulation of banks has been addressing mismatches between the liquidity of banks’assets and liabilities. Under the Basel III rules, banks must hold enough highly liquid assets to cover liability requirements through periods of stress.
Bodies such as the US Securities and Exchange Commission and the International Organization of Securities Commissions have sought to mitigate liquidity risk in investment funds through rules and guidance aimed at limiting mismatches between the liquidity of fund investments and the redemption terms offered.
