Market liquidity and its incorporation into risk management

The excessively optimistic assessment of market liquidity, i.e. the belief that transactions can be settled at current prices without any notable delays or transaction costs, may be a serious threat to financial stability–the near failure of the LTCM hedge fund in 1998 was a case in point. Admittedly, the financial community today appears to have a better grasp of the risks arising from liquidity illusion. The fact nonetheless remains that current risk management tools, particularly the most common Value at Risk (VaR) measures, do not capture this complex component of market risk satisfactorily. In fact, standard VaR calculations do not take specific account of the risk to which a portfolio is exposed at the time it is liquidated. This article aims to explore the different aspects of liquidity risk and provide signposts to methods for incorporating this risk into existing risk control tools. We fi rst examine “normal” or average liquidity risk, which corresponds to the costs of liquidating or hedging a position in tranquil periods, then illiquidity risk that arises in crisis periods and results in the market’s inability to absorb order flows without violent price adjustments. Two separate methodologies, which must nonetheless be combined in a comprehensive approach, are required to analyse these two situations. In the first case we seek to assess the frictions that emerge in imperfect markets by using bid-ask spread measures and by analysing the negative impact on prices resulting from the liquidation of a sizeable portfolio. In the case of extreme risk, we assess the potential consequences of occurrences that are rare, fundamentally uncertain and systemically important. In each case, we suggest and describe a number of techniques that aim to incorporate these elements into the risk measurement and management systems used by private market participants, while underscoring the obstacles to application given the frequent unavailability of the data required. We show that these techniques are relevant because they provide a more cautious and more realistic assessment of financial institutions’ exposure to risk. Lastly, it is in market participants’ own interest for central banks and supervisory bodies to have at their disposal the information required to construct indicators for monitoring market liquidity or conducting suffi ciently comprehensive stress tests in order to assess the fi nancial system’s resilience to liquidity shocks, while taking into account all the externalities that market participants do not individually consider.