Liquidity Risk: Definition, the Two Types, and What March 2020 Showed

Michael Whitman · Trading since 2017, full-time since 2020 · YouTube creator, 137K subscribers · Published 2026-09-14 · Updated 2026-10-27 · Reviewed 2026-10-27

Liquidity risk is the risk of being unable to sell an asset near its value (market liquidity risk) or to meet a payment when it falls due (funding liquidity risk). In March 2020 every $1 billion traded in the high-yield bond fund HYG moved its price 4.70 times as much as in 2019, though trading had nearly tripled.

The reason the two share a name is that each reliably produces the other.

How it works: market and funding liquidity risk

Market liquidity risk is about the asset. You hold something worth 100 on paper and the only available buyer will pay 80, so the paper value is not a price you can obtain.

Funding liquidity risk is about you. An obligation falls due, the cash is not there, and no amount of being solvent on paper resolves it by the deadline.

Each produces the other. A funding shortfall forces selling into a weak market; forced selling depresses prices, which triggers margin calls at other holders and creates funding shortfalls for them.

Why solvency does not protect you

Solvency is about the balance sheet. Assets exceed liabilities, so in an orderly wind-down everybody is paid.

Liquidity is about the calendar. Assets realizable over five years cannot meet a liability falling due on Friday, whatever the totals say. An institution that misses a payment is treated as failed regardless of its balance sheet, because counterparties cannot distinguish “will not” from “cannot yet.”

A worked example

A fund holds illiquid assets and offers daily redemptions. In calm conditions redemptions are modest and easily met from cash.

A period of poor performance triggers larger redemptions. The cash buffer is exhausted and the fund must sell holdings that take weeks to sell properly.

Selling quickly means selling badly, which lowers the reported value, which prompts further redemptions from holders who can now see the decline. The mismatch was structural from the first day, daily liquidity promised against assets that never had it, and the calm period simply concealed it.

A real one: Silicon Valley Bank, March 2023. The Federal Reserve’s review of the failure, published 28 April 2023, reports deposit outflows of over $40 billion on 9 March and $100 billion more expected by management the next day. California’s banking regulator closed the bank on 10 March. The same review says the bank had failed its own internal liquidity stress tests.

Why banks carry it by design

Banks run this deliberately. Deposits repayable on demand fund loans lasting decades, and the business model is that not everybody asks at once. That is why bank runs are self-fulfilling: the belief that others will withdraw is reason enough to withdraw.

Deposit insurance and central bank lending exist for exactly this. They remove the incentive to be first in the queue, which made runs rare rather than impossible. Funds offering daily dealing on illiquid assets repeat the structure without that backstop.

The original data

Market liquidity can be measured from public prices. A common yardstick, the Amihud measure, divides a day’s price move by the dollars traded that day: the more a given amount of trading moves the price, the thinner the market. We computed it for three funds from Yahoo Finance daily data: SPY (US stocks), HYG (high-yield corporate bonds) and LQD (investment-grade corporate bonds). Each day’s value is the absolute percentage change in the adjusted close, so dividends do not count as moves, divided by the close times the shares traded, in billions of dollars. Each month’s median is set against the median day of 2019.

March 2020 was the worst month since 2019 for all three, and worst of all for the bond funds. HYG’s median day traded $4.67 billion, 2.99 times its 2019 median of $1.56 billion, yet its median move rose from 0.15% to 1.89%. More trading moved the price far more per dollar, which is what a market losing its liquidity looks like from outside.

A sharp sell-off is not the same thing. In April 2025 SPY’s measure rose only to 1.18 times its 2019 level and HYG’s stayed at 0.98 times: prices fell hard, but trading grew in step. Each fund’s monthly multiple is in the data file. The measure is a rough gauge: it mixes ordinary volatility with thin trading, and these funds have grown, so their later months sit lower partly for that reason.

Checked against Nasdaq. On Nasdaq’s closes and volumes, prices only, March 2020 came out at 2.85 times 2019 for SPY, 4.59 for HYG and 2.93 for LQD, against 2.85, 4.49 and 2.91 from Yahoo on the same rule; in March 2020 the median ratio of Nasdaq volume to Yahoo volume was 1.0000 for all three. The small gap comes from the 2019 baseline: HYG’s closes match to the cent in both sources that year, but its volume differs by more than 0.1% on 93 of 252 days. Nasdaq’s 17 April 2026 volume of 9,999,999 and a stale 20 April 2026 row were left out.

Funding liquidity has a price you can watch too. We took FRED’s daily rate for three-month commercial paper issued by AA-rated financial companies and subtracted the three-month Treasury bill rate, on the 6,738 days from 2 January 1997 to 24 September 2026 when both were published.

It moves in days, not years. On 2 March 2020 the gap was 21 basis points; by 16 March it was 111 and by 25 March 257, twelve times its starting level in just over three weeks. Only 267 of the 6,738 days were at 100 basis points or more, and 137 of those were in 2008. The median in 2025 was 9 basis points, and on 24 September 2026 the gap was zero. The gap also carries some credit risk, so read it as a stress gauge rather than a pure measure. Every day is in the spread data file.

What actually defends against it

Hold cash. Unexciting, and the only defense that works in every scenario, which is why it is the one most often trimmed during good periods.

Match maturities. Funding long assets with long liabilities removes the mismatch at the cost of flexibility and, usually, some return.

Committed facilities. A pre-agreed borrowing line helps, and the ones that matter are the ones the lender cannot withdraw at the moment you need them.

And structural tools for funds. Notice periods, swing pricing and gates align what is promised with what the assets can deliver; imposing them during a crisis does far more damage than having them from the start.

How it is measured

The liquidity coverage ratio requires banks to hold enough high-quality liquid assets to survive a specified thirty-day stress, and the net stable funding ratio requires long-term assets to be funded by stable sources rather than overnight borrowing. Both came out of the 2008 experience.

Redemption stress testing applies assumed outflow rates to a fund and asks whether the portfolio could meet them without distressed selling. All three specify a scenario rather than fit a distribution, because the history contains few examples of what they protect against.

How this connects

The bid-ask spread is the first place market liquidity risk shows. It widens as a market maker steps back.

Funding liquidity risk reaches private traders as a margin call, which is what avoiding a margin call is about.

Some assets are illiquid by nature. A penny stock, a thinly traded corporate bond or real estate can take far longer to sell than a listed fund of large companies. A closed-end fund never has to sell holdings to meet redemptions, because investors sell their shares to each other instead.

At scale, the loop becomes systemic risk, and circuit breakers pause trading so forced selling cannot feed on itself. A money market fund or a Treasury bill is the everyday buffer.

On a chart the word has a narrower meaning: the stop orders resting beyond obvious highs and lows, as the liquidity page measures.

When it fails

The characteristic failure is a liquidity buffer sized against normal conditions. A treasurer models outflows on historical patterns and holds a buffer covering the worst month in the data. In a genuine stress, outflows exceed anything in that history because everybody is doing the same thing at once, while the assets earmarked for sale have become the hardest to sell. Both sides of the calculation deteriorate together, because of the same event.

A second failure is confusing solvency with liquidity. Being right about value does not pay a bill on Friday.

A third is relying on a facility that can be withdrawn, which is what happens when it is needed.

A fourth is offering daily dealing on assets that do not trade daily.

And a fifth is assuming a liquid market stays liquid. Depth is provided voluntarily, and the providers withdraw when it costs them, which is what HYG’s March 2020 numbers recorded.

Questions people ask

What are the two types of liquidity risk?

Market liquidity risk, where an asset cannot be sold near its value, and funding liquidity risk, where a payment falls due and the cash is not there. Each tends to cause the other.

How is market liquidity risk measured?

By the cost of trading: the bid-ask spread, the depth showing at each price, or how far the price moves per dollar traded. On that last measure HYG moved 4.70 times as much per $1 billion in March 2020 as on its median 2019 day.

Is liquidity risk the same as credit risk?

No. Credit risk is a borrower failing to pay; liquidity risk is not being able to sell or raise cash in time. They often arrive together, which is why the commercial paper gap above carries some of both.

Can a solvent company fail from liquidity risk?

Yes. Silicon Valley Bank faced over $40 billion of withdrawals on 9 March 2023 and was closed the next day, while the Federal Reserve’s review notes it had already failed its own liquidity stress tests.

Related

Bid-ask spread covers the everyday cost of the market liquidity this page is about losing. Market risk covers the price exposure this one interacts with. And settlement risk covers a timing failure with the same shape, while deposit risk covers what a bank run means for the money a customer keeps there.

This page is educational, not financial advice. Test every idea on your own charts before risking money.