Liquidity - Investors should be concerned

If there is an adverse market move and you want to change portfolio allocations and sell some securities, will you get a fair price? Any of the downside situations that will be faced by investors will face a shortage of liquidity. This is different than thinking about illiquid investments where the knowledge concerning illiquidity is known. 

More important is the vanishing of liquidity for instruments that are usually liquid. Every investor should be prepared for a liquidity surprise. Like entering a theatre, the critical risk manager knows where are the exits. This issue is antiseptically discussed in the Global Financial Stability Report of the IMF for April 2019 as a "Special Report: Liquidity in Capital Markets". It is a problem but the report does not sound an alarm bell. 

Two issues jump out when thinking about market liquidity. One, the market structure that provides liquidity has changed radically since the Financial Crisis. It does not have the capacity to serve all investors who may want to sell in a crisis. High frequency and electronic trading makes liquidity in a crisis more fragile and the spread of technology is not equal. The trading future has come sooner for some. Two, the concept of market liquidity is fluid. Some asset classes are more liquid than others and market liquidity last year is the not the same as this year.

Market liquidity is dynamic. By some measures and for some markets, liquidity could be better than a decade ago, but there are some clear hot spots. Traders break up orders to reduce the price impact of trades and high frequency market-makers can make tight bid-ask spreads, but a shock can cause this liquidity to disappear quickly. 

Investors should conduct a liquidity assessment. If there is a liquidity flash crash, how will you assess this risk? How great a deviation from fair value will you expect from a liquidity shortfall? Is your portfolio protected against a liquidity shock? Given a specific shock, walk through what will be sold, how will it be sold, and what is the expected impact. Liquidity is like water. The price is low until it is really needed.