Types of liquidity risk

There are two types of liquidity risk :
a) Asset Liquidity Risk
b) Funding liquidity risk

Asset liquidity risk is the risk that the liquidation value of the assets may differ significantly from the current mark-to-market values. When unwinding a large position or when the market circumstances are adverse, the liquidation value may fall well below the fair or intrinsic value.

Asset liquidity is low when it is difficult to raise money by selling the asset. This typically happens when selling the asset depresses the sale price. Asset liquidity depends on the relative ease of finding somebody who takes on the other side of the trade. When it is difficult to find such counterparties, liquidity is low. There are three forms of asset liquidity:

v the bid–ask spread, which measures how much traders lose if they sell one unit of an asset and then buy it back right away;
v market depth, which shows how many units traders can sell or buy at the current bid or ask price without moving the price;
v market resiliency, which tells us how long it will take for prices that have temporarily fallen to bounce back. While a single trader might move the price a bit, large price swings occur when “crowded trades” are unwound—that is, when a number of traders attempt to exit from identical positions together.

Funding liquidity risk refers to the inability to meet payment obligations to creditors or investors. Funding liquidity risk can thus take three forms:
v margin/haircut funding risk, or the risk that margins and haircuts will change;
v rollover risk, or the risk that it will be more costly or impossible to roll over short-term borrowing;
v redemption risk.

Most financial institutions fund long term assets with short term sources of funds. This maturity mismatch can lead to problems if depositors/investors start withdrawing their money simultaneously.

Funding liquidity problems also arise because most trading positions are leveraged. Traders post collateral in exchange for cash from a broker. The value of the collateral is constantly marked to market. If this value falls, the market participant may be asked to deposit some additional payment called the variation margin to keep the total amount held above the loan value. Without adequate liquidity to make these margin payments, market participants can find themselves in trouble.

Typically, when a trader, purchases an asset, the trader uses the purchased asset as collateral and borrows (short term) against it. However, the trader cannot borrow the entire price. The difference between the security’s price and its value as collateral is called the margin or haircut. The haircut must be financed by the trader’s own equity capital. Haircuts are adjusted to market conditions on a daily basis. Since traders are leveraged and carry little capital in relation to their assets, increasing the haircut may force them to sell part of their assets when liquidity dries up in the market.

Financial institutions that rely substantially on short-term (commercial) paper or repo contracts have to roll over their debt. An inability to roll over this debt is equivalent to margins increasing to 100 percent, because the firm becomes unable to use the asset as a basis for raising funds. Similarly, withdrawals of demand deposits from an investment fund have the same effect as an increase in margins. When the time is due for redemption or if investors want to make premature withdrawals, banks can find themselves in serious trouble if they do not have adequate liquidity.