Understanding liquidity risk: causes & management

April 16, 2024 

Liquidity risk is an important part of running a business. As a business grows and becomes more complex, liquidity can become a lot more complicated, and hiccups in cash flow can be disastrous.

Liquidity risk refers to the risk of losses being incurred due to a lack of liquidity. Measuring and mitigating this risk is therefore crucial.

Liquidity risk also refers to market liquidity risk, whereby a market might have the danger of being too illiquid. Therefore, assessing the liquidity risk of a market before entry is crucial.

What is liquidity risk?

If liquidity is how easily an asset can be converted into cash, then liquidity risk is how much liquidity an asset has, and more importantly, the risk of how difficult it might be to sell.

There are two types of liquidity risk to be aware of:

     Funding liquidity risk

Funding liquidity risk (also known as cash flow liquidity risk) is the risk level of how easily they can fund their liabilities, and also how good their cash flow is. Essentially, this is how much cash a business has to hand, and whether they can pay back their debts if they had to.

To obtain a basic reading of the funding liquidity risk, the current ratio can be calculated, which is the current assets divided by the current liabilities. It can also be measured using the quick ratio, which instead uses ‘quick assets’ such as cash to calculate how liquid a market might be.

     Market liquidity risk

Market liquidity risk refers to the ability to exit a position in a stock or security. An asset with high market liquidity risk would mean that it can be bought, but is difficult to sell, and therefore carries a risk of loss as the price could drop before a buyer is found.

For example, if liquidity in forex is high, it means that the spread is incredibly small, the prices are reliable, and people can easily enter and exit positions at their desired price. Low liquidity would mean wider spreads.

What causes liquidity risk?

Liquidity risk can be caused by a multitude of different factors. As higher risk can mean higher reward, it often pushes companies and markets to invest in riskier and less liquid assets.

Funding liquidity risk causes

Funding liquidity risk can be increased by having too many assets that cannot be quickly sold or converted into cash. 

Assets can also change in their liquidity. For example, if a company has holdings in real estate, and the real estate market plummets, the liquidity of the asset held by the company is likely to become very low, as nobody wants to buy property in a spiralling market.

Many companies also rely on credit lines to increase their liquidity, which can be disrupted. This can have a knock-on effect, and companies can then find they have disruptions to other areas of the business, triggering a liquidity crisis if their obligations cannot be met.

A liquidity crisis can also be caused by something as simple as timing. If a company’s liabilities are due before the assets can be converted into cash, then this can create serious liquidity problems. 

Market liquidity risk causes

Market liquidity risk is increased for several reasons, but is often based on the amount of traders in a particular market and whether there are an equal number of buyers and sellers.

In times of a financial crisis, there may be imbalances in the market which contribute to a decrease in liquidity, and potentially a liquidity crisis. 

An extreme case is often referred to as liquidity freeze.

Managing funding liquidity risk

In terms of funding liquidity risk, managing this can be a huge responsibility, particularly in large companies. 

The responsibility of managing liquidity risk will fall on those responsible for financial management and depends on the structure of the company. As companies vary in size and function, the requirements for liquidity risk management may be different. A company will rely on their CFO or their treasury department to ensure that cash flow is consistent and that a company can meet its financial obligations if it needed to.

These bodies can use various methods and plans to ensure that risk is kept sustainably low, and the business can continue to generate profit without risk of defaulting.

Companies can use a liquidity coverage ratio (LCR) to give an overview of their highly liquid assets, and how able they are to use them to meet their short-term obligations.

Other tools could include a contingency funding plan (CFP) which is a liquidity management tool which outlines the decision framework and plan of action if a liquidity crisis is imminent.

Managing market liquidity risk

Liquidity risk can be managed in markets with liquidity pools to ensure that there is always enough liquidity for buyers and sellers to enter or exit positions.

Generally, market liquidity can be increased by increasing the amount of buyers and sellers, but obviously, this is out of the participants’ control. Markets with very high liquidity, such as major forex pairs, have an assurance of liquidity as there are always buyers and sellers ready.

Liquidity in the forex market can be increased by smoothing out the infrastructure – essentially making it easier to enter and exit positions. 

In new markets, such as crypto, liquidity pools can provide a way to create liquidity in extremely illiquid environments. This can be a way to get a new crypto project off the ground, which might previously have been stuck with liquidity issues.

Decentralised exchanges (DEXs) such as Uniswap also provide a self-sufficient way to inject liquidity into the market without an external liquidity provider.

Conclusion

If you’re looking for a liquidity provider, then LiquidityFinder is a professional network of liquidity providers designed to help you find the best option.

At LiquidityFinder, we have a range of risk management tools to help you access liquidity for your business and manage risk.

Author

Caleb is a financial copywriter with a specialisation in fintech and forex. Former copywriter at Barclays and Paysafe. Contributing writer for LiquidityFinder. You can message Caleb here.