Liquidity risk in capital markets: the one investors overlook
Liquidity risk is a factor that is easily overlooked by investors.
Naturally, investors tend to focus on factors likely to influence asset prices directly: economic growth, inflation, interest rates and corporate earnings. Yet liquidity, while less discussed, is an important force shaping financial markets. It influences how assets are priced, how quickly markets recover from shocks and, ultimately, how easily investors can buy or sell investments when they need to.
Indeed, many financial crises are based on liquidity crises. Once liquidity disappears, even high-quality assets see rapid price falls. Therefore, understanding liquidity is central to understanding capital markets.
Key Takeaways
- Liquidity determines how easily an asset can be converted into cash without significantly affecting its price or reducing its value.
- Market liquidity and funding liquidity are closely connected, and pressure in one can quickly create pressure in the other.
- Strong liquidity supports efficient price discovery, lower transaction costs, investor confidence, and more effective capital raising.
- Liquidity risk often becomes most visible during periods of market stress, when investors need immediate access to their capital.
- ETFs can provide liquid access to less liquid underlying assets, but temporary pricing differences may emerge when market conditions deteriorate.
In this article
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Understanding liquidity in capital markets
A highly liquid asset (shares in large multinational companies, major government bonds and leading currencies such as the US dollar) has a large number of buyers and sellers actively trading in the market. Liquidity means that transactions can be completed quickly, at relatively low cost and with minimal impact on market prices.
Less liquid assets may trade infrequently, have relatively few potential buyers, or require investors to accept a substantial discount to complete a sale. Among these are commercial property, infrastructure investments, private equity holdings and many smaller company shares.
Liquidity is therefore not simply about whether an asset can be sold (almost any asset can eventually be sold at the right price). Rather, liquidity reflects how easily the asset can be converted into cash while preserving its value.
Liquidity is a term often used broadly but in fact encompasses two interrelated concepts.
Market liquidity refers to the ability to trade securities without causing large price movements. Deep markets with many participants generally exhibit strong market liquidity.
Funding liquidity refers to the availability of cash or financing. Banks, investment funds and financial institutions rely on funding liquidity to meet payment obligations, finance trading positions, and satisfy customer withdrawals.
The two are closely connected. If funding becomes scarce, investors may be forced to sell assets quickly. Where there are insufficient available buyers, market liquidity reduces and prices to fall further. Depressed prices may then create additional funding pressures, reinforcing the cycle.
Liquidity supports efficient markets
Liquidity is a prerequisite for efficient capital markets and it performs several functions.
Price Discovery: where there are many buyers and sellers continuously trading, market prices tend to reflect available information more accurately.
Transaction Costs: Narrow bid-offer spreads allow investors to enter and exit positions more efficiently (at lower cost), improving overall market efficiency.
Investor Confidence: Investors are generally more willing to commit capital when they have confidence they can access it again if circumstances change.
Economic Growth: Companies and governments can raise capital more efficiently.
Once liquidity disappears, however, the effects can spread rapidly across financial markets. This was notably the case in the Global Financial Crisis of 2008, when markets for mortgage-backed securities and other structured products effectively froze as confidence collapsed. Institutions holding these assets found that they could no longer sell them except at heavily discounted prices.
During such periods of market stress, Central Bank intervention is crucial to support liquidity. By acting as lenders of last resort, they can provide short-term funding to banks and other financial institutions experiencing temporary liquidity shortages.
During major crises, central banks may also purchase government bonds or other financial assets, injecting liquidity directly into financial markets through programs such as quantitative easing (QE).
Liquidity risk during market stress
Liquidity risk tends to emerge precisely when investors most need access to their capital. Two examples:
- An investment fund offering daily redemptions may hold assets that cannot easily be sold within a single day. In the face of heavy withdrawals, fund managers may be forced to sell their most liquid holdings first, potentially leaving remaining investors with an increasingly illiquid portfolio.
- Investors using borrowed money may be forced to liquidate assets quickly if lenders demand additional collateral, creating further downward pressure on prices.
ETFs and market liquidity
Perhaps the most topical concern over market liquidity relates to the rapid growth of exchange traded funds (ETFs).
Many ETFs provide investors with highly liquid access to asset classes that are themselves relatively illiquid, such as corporate bonds, bank loans or emerging market debt.
Under normal conditions, the ETF structure has generally proved resilient. Market makers and authorized participants help keep ETF prices closely aligned with the value of their underlying assets.
However, during periods of market stress, price differences can emerge between ETFs and the securities they hold, reflecting changing market conditions and temporary reductions in liquidity.
The lesson for investors and portfolio managers is while liquidity risk may be relatively less visible than other risk factors, it should never be discounted or underestimated.
Intuition Know-How has a number of tutorials relevant to the content of this article:
- Asset Management – Liquidity Risk
- Financial Markets – An Introduction
- Investment – An Introduction
- Liquidity Risk – An Introduction
- Money Markets – An Introduction
- Corporate Finance – Capital Structure & Liquidity
- Liquidity Risk – Measurement
- Asset Classes – Types
- Asset Classes – Investing
Frequently Asked Questions
What is liquidity risk in capital markets?
Liquidity risk is the possibility that an asset cannot be sold quickly without accepting a significant discount or causing a large price movement. It matters because investors may need access to cash precisely when markets are under stress. Even high-quality assets can fall sharply when buyers disappear and transactions become difficult.
What is the difference between market liquidity and funding liquidity?
Market liquidity refers to the ability to trade securities without causing large price movements. Funding liquidity refers to the availability of cash or financing needed to meet obligations, fund positions, or satisfy withdrawals. The two are closely linked because funding pressure can force asset sales, weaken market liquidity, and push prices lower.
Why is liquidity important for efficient capital markets?
Liquidity supports efficient price discovery, lower transaction costs, investor confidence, and more effective capital raising. When many buyers and sellers are active, prices are more likely to reflect available information accurately. Investors are also more willing to commit capital when they believe they can access it again if their circumstances change.
What happens when liquidity disappears during market stress?
When liquidity disappears, markets can freeze and asset prices may fall rapidly. Investors that need cash can be forced to sell at heavily discounted prices, while declining prices can create further funding pressure. This cycle can spread across financial markets, as seen during the Global Financial Crisis when structured-product markets became difficult to trade.
How can investment funds create liquidity risk?
Investment funds may offer daily redemptions while holding assets that cannot be sold within a single day. During heavy withdrawals, managers may have to sell the most liquid holdings first. This can leave remaining investors exposed to an increasingly illiquid portfolio and make it harder for the fund to meet additional redemption requests.
How can ETFs be affected by market liquidity?
Many ETFs offer liquid access to asset classes that may be relatively illiquid, including corporate bonds, bank loans, and emerging-market debt. Under normal conditions, market makers and authorized participants help keep ETF prices aligned with underlying assets. During market stress, price differences can emerge as liquidity in those underlying securities declines.
Liquidity risk can affect asset prices, transaction costs, funding conditions, and market stability, particularly during periods of stress. Intuition helps financial services teams build the capital markets knowledge needed to understand these risks and make informed investment decisions. Fill out the form below to discuss your learning priorities.
