Liquidity risk, both in terms of funding and asset (market) illiquidity, has been recognized to be among the most prevalent and pernicious risks facing financial markets and institutions in terms of their function and stability. As financial intermediaries (banks, broker-dealers, insurers, pensions, and asset managers, including hedge funds) become more market-oriented in their operation, the effect of liquidity risk upon their cost structure and borrowing capacity (i.e. access to credit) is increasingly evident. Liquidity risk is now being studied by academics, practitioners and policymakers as the primary cause of anecdotal phenomenon deemed asset bubbles, financial contagion and market crashes. Furthermore, liquidity risk, both fundamentally and in its manifestation, is an extremely complex phenomenon which manifests itself in spread risk, counterparty risk and settlement risk, and thus has implications for credit risk and operational risk. Liquidity risk also undermines price efficiency and influences complex market behaviors such as strategic and predatory trading.
The LRC will attempt to bridge the gap between different concepts of liquidity by organizing and sponsoring forums for discourse among academics, practitioners, and policy makers, and to promote the cultivation and dissemination of applied research relating to all aspects of liquidity risk that affect the stability and function of financial markets and institutions.
The LRC is comprised of academics, practitioners, and policymakers involved in researching liquidity risk and its effects on market stability within the context of diverse institutional and industry settings, and in relationship to public policy.
Fundamental questions that the LRC will address include the following:
- Given the role of markets, financial intermediaries, and arbitrage on the rationalization of prices, what effect does market liquidity have on price formation?
- How does funding (balance sheet liquidity, access to credit) and asset liquidity interrelate?
- What is the interrelationship between asset liquidity, risk-based leverage structured products, margining rules, and counterparty risks?
- What is the relationship between real (strategic, i.e. imperfectly competitive market (micro-) structure, and managerial) options and liquidity risk, and how can market mechanisms serve as a solution?
- What is the appropriate role for nonmarket mechanisms and how can market and nonmarket mechanisms be harmonized to address liquidity risk?
Areas for exploration: liquidity premia and “demand for immediacy”; asset liquidation values and investment horizons of investors; bubbles, crashes, contagion effects and cross-correlations; price effects of strategic and predatory trading on illiquid assets; asset substitution and the “paradox of liquidity”.