Underestimating liquidity risks: How investors can suffer

Risk management models used by professional investors often assume that securities can be traded infinitely. When liquidity dries up, especially in a systemic way during periods of crisis, it becomes very expensive to trade

"When there is rain, umbrellas become expensive. But when there is no rain, nobody cares about the umbrella and the prices are low. The case of Liquidity is similar", says Professor Yakov Amihud, Ira Rennert Professor of Entrepreneurial Finance at the Stern School of Business, New York University. Prof Amihud has been actively researching the effects of liquidity of assets on their returns and values, and the design and evaluation of securities markets' trading methods for over three decades.

In conversation with Dr Nupur Pavan Bang of the Insurance Information Bureau of India and Prof Vikram Kuriyan of the Indian School of Business, Prof Amihud explains that liquidity risk is often ignored by investors. Risk management models used by professional investors often assume that securities can be traded infinitely. When liquidity dries up, especially in a systemic way during periods of crisis, it becomes very expensive to trade.

Firms like Morgan Stanley and Long Term Capital Management have suffered huge losses due to underestimating the cost of liquidity.

So when does liquidity dry up? "It is a chicken and egg story", says Prof Amihud. When prices fall, traders with leveraged positions need to come up with additional funds. If funding is too costly, traders must liquidate part of their positions and this makes stocks less liquid. When stocks become illiquid, their prices fall further; this exacerbates the problem of illiquidity. In addition, information asymmetry is an important determinant of illiquidity. When there is overall panic and information gaps between traders widen, transaction costs go up and liquidity dries up.

The introduction of high frequency trading (HFT), algorithmic trading and technology improvements in terms of direct market access and co-location has not hurt the markets in terms of overall liquidity. Every generation, there are some people who are more technologically advanced than the others and consequently they have an advantage over the others. In earlier times, people who had telephones had an advantage over those who did not have telephones. Then came computers. Initially, only a few had computers. Now, everyone has it.

It's not an arms race, which imposes a dead-weight cost with no benefit. For example, when both India and Pakistan did not have nuclear weapons, they were equal. Now both have it, and they are still equal, but after burning billions of dollars. Similarly, people argue that when there was no HFT every one was equal in terms of technology. And now with HFT, everyone might eventually reach there and then again everyone will be equal. So why have it? Well, by improving the speed of transactions, HFT helps improve stock liquidity. Limit orders are tighter (have narrower gap between the buying and selling price), which benefits all traders who can trade at lower cost. This applies particularly, to large and more liquid stocks, in which HFTs are more actively involved.

The level of illiquidity and its price have declined over time. This is not an anomaly which will disappear once the market finds out about it. It will stay there and benefit all traders and the economy at large.

On being asked about liquidity in the Indian markets, Prof Amihud says that India is among the least liquid markets in the world. Ironically the corporate world would get upset if the Reserve Bank of India (RBI) would raise bank interest rates. Yet, they are not worried about the illiquidity in the securities markets, which raises their cost of capital. If the Securities Exchange Board of India (SEBI) comes out with a regulatory scheme that would make the market more liquid, it will reduce the corporate cost of capital, akin to the RBI lowering interest rates.



Abhas Bhushan

3 years ago

With all due respect to the authors and the comments herein my take is –
The article very well describes and captures the effect of liquidity with the example of rain and umbrella. No where the article says that it is the only factor affecting fall / rise of scrips but yes it is one of the most underestimated factor. Someone pointed out LTCM’s example – if u read the book “When Genius Failed” – u’ll find that the liquidity was the sole factor (and effects emanating from it) for the birth of LTCM let alone reasons for fall of LTCM.
No-one is denying that counter-party risk is a major risk but have we not in our lives as well experienced the effect of Liquidity / illiquidity? Can we ignore the basic principal of economics related to velocity of money; if u keep on taking out money and store it (causing illiquidity in the market) will it function the same way as it should be??
Trading of any kind is dependent on buyers and sellers and hence demand and supply; buyers and sellers will always be there...but the point being made in the article is that there is a cost associated to being able to buy or sell.


Santosh Kanekar

In Reply to Abhas Bhushan 3 years ago

1. Liquidity is the effect not the cause - that is what I'm trying to point out

2. In cash markets esp in India, short selling is allowed only intraday and non-futures market is subject to Daily limits beyond which trading stops. So there is no issue of liquidity here. As much free float is present, there will be "liquidity"

3. In Futures (cash settled futures) again the exchange places a limit on Open Interest which is related to the Free float. no liquidity problems here.

4. The problem starts in Options where Open interest can be written unlimited esp in Index futures. The problem is not liquidity - the problem is counter party risk. If people write 1L crore options and the underlying is 5k crore then if delivery is asked for,then, it becomes a problem. If cash settled no problem

5. India is one of the TOP 5 stock exchanges in the world! in terms of number of contracts executed every day so how is it a illiquid market?

6. the most liquid market ie US froze with the AIG crisis. why? coz when CDS which were sold (which were nothing but put options) were asked to be delivered, AIG came into a counter party risk and liquidity froze.

7. Money is fungible. dont confuse velocity with quantum. cash whether it sits in a drawer or buy a share is liquid as long as there is another party to take transaction - counter party

hope this clarifies

Vinay Joshi

In Reply to Abhas Bhushan 3 years ago


In the first place the authours of this article have various mind thoughts, getting - irrational nuclear aspects - in their 'so called supportive', bid to establish a point.

In that event i can also talk of AK-47 inventor [ i know neither the authours will know details].

How much is velocity of money? Not directly related to M3? What is M3?


No Its not liquidity, 'FRAGILE FIVE', as the investors see is the concern!? OK!

C'mon authors answer as you all are professionals, Ms.Nupur, Mr.Vikram.


Vinay Joshi

In Reply to Abhas Bhushan 3 years ago









Santosh Kanekar

3 years ago

An unnecessary attempt to complicate things.

Prices are a reflection of Demand and Supply and the volume available. If someone can "liquidate" that means there is a seller and there is a buyer and volume is available.

LTCM and London whale (not mentioned but same category) happened because the trades taken were sound but they took up positions which were very large. When other traders found that out, they stopped buying the options which were being sold causing a counter-party risk and "freezing" of the market. This was more a predatory trading tactic than a "systemic" issue.

Margin calls also cause the same symptoms without liquidity being an issue eg 400 tons sell off in Gold which happened in 2013 and two days back Natural Gas sharp correction which happened.

The bigger "systemic" issue is Counter-party risk or the creation of contracts with no one to honor them. The biggest issue the world faces today are ETFs (esp the inverse ETFs) and Credit Default swaps: both have reached proportions far in excess of the underlying. In India, it is the derivatives market. On a high volume day, NSE records cash transaction of 5000 cr and Options turnover of 1 lakh crore!


Vinay Joshi

In Reply to Santosh Kanekar 3 years ago


Absolutely pointed it out to London Whale, now what the authours can state?

When oil was $145, the derivatives & futures were more in volume value expansion than all the stock indices put together world over!
Liquidity was always there!

Silver was high coz of margins imposed lowered.

JP Morgan is acceding to record $13bn settlement with regulators on mortgage securities! [as reported by WSJ].

I'm not going into banking industry settlements, US alone it is 100's of bns.

I hope the authours of the article answer!


Vinay Joshi

3 years ago

Dr. Nupur Pavan Bang & Prof.Vikram Kuriyan,

If traders are liquidating how liquidity will be an aspect?

Entrepreneurial finance is different from traded securities liquidity.

Ms.Nupur & Mr.Vikram, at the start of the week world over all indices had slipped! Today Dow & Nasdaq lowest.

Why is India's premium over other emerging markets rising?

PEx MSCI India is 105.30 against PEx MSCI for Emerging markets 86.79 - Jan 1 2013 to Jan 24 2014! In other words the valuation gap is widening.

Now where does your theory get into & fit to advance a thought line of liquidity? Kindly explain.

Indian scrips can't be immune to global contagion but can be vulnerable to other parameters in economy stability in next couple of months.

I hope you've heard of Premise Data Corp; a fledgling data collection & analysis co. based out of San Francisco, funding from Google Ventures,Andreesen Horowitz, Harrison Metal, Google computer scientist Joe Reisinger & Quant Analyst David Soloff.

As of now they are not putting any figure on liquidity but David Soloff is more interested, Prof. Amihud.

So in system theory, liquidity just a concept to stock reference.


Arthakranti is only half-way illumination

Arthakranti is an interesting take on the Indian economy. However, informed discussions and revision are required to take India forward

Innovation is the key to development. A country with 67 years of democratic rule, experimented with several economic policies with not much success. The proposals of Arthakranti awaken fresh thinking but many proposals need informed discussion and revision.

Empowering Democracy

Monthly allowance to politicians in the place of already ill-spent annual grant of Rs2 crore for each Member of Parliament (MP) and all the legislators. There is no social audit for such expenditures. In fact, there is a case for removal of this extravaganza that is hurting the poor by depriving them of the subsidy or insurance.

Instead, I would prefer tax-exempt donation from all corporate, annually, to an electoral fund to be maintained by the Election Commission. Election expenditure can be given out of this pool three months prior to the tentative period of elections. The release should be related to the size of the electorate and the geographical space to be covered, with the type of terrain to be factored into it.

'Irrespective of the party to which one belongs, every person who stands for elections could be given this, with a cap on the number of candidates applying for the release. The Election Commission can disqualify candidates with criminal record, apart from those who are mentally retarded and other existing disqualifying criteria on record.

This would help some of the intellectuals joining the Electoral College to establish cleaner political system. Any corporate entity representative in the upper house should be able to fund for himself/ herself and not depend upon the fund. The criteria for release should be transparent and can even be legalised through a constitutional amendment.

Developed India

Rather than seeking urbanisation as this (urbanisation) is a continuing process and is happening all through at an accelerated pace, we should provide amenities to rural areas. We would have achieved urbanisation—good schools; good hospitals, good roads, safe drinking water, drainage and sewerage system and private latrines, and so on. The resources should be drawn preferably from sub-regional fiscal allocations – i.e. the panchayats and blocks/mandals. For the assessment of needs, it can best happen at the village level and not at the district and State levels. Therefore, there is need for insisting on a transparent mechanism of sub-regional allocations and releases of the resources.

The ability of the villages to levy taxes and cess just does not exist; and even if it existed, it has to be integrated with the regional resource pool. For example, property taxes, drinking water cess or drainage cess can be collected at the village level and their deployment for effective maintenance can be ensured through a decentralized monitoring mechanism that should include professional surveillance and social audit. The Fifteenth Finance Commission could be working a way out on this front.

Fiscal deficit is bound to exist to some degree or the other as the State has a constitutional responsibility to ensure welfare, safety and security of all the citizens. National calamities, defense, and high quality research shall be the domain of Central government.

Black Money and Parallel Economy

As Anil Bokil rightly investigates, we have excess money in circulation than the goods and services produced – the raison d’etre for persisting inflation and deceleration in growth. The window is higher denominations, especially Rs500 and Rs1,000. All the currency seizures by the Anti-Corruption Bureau (ACB) and Central Bureau of Investigation (CBI) raids were precisely in these currencies. All the money stashed in foreign accounts of Indians through hawala deal is hidden.

While the monetarists and currency managers argue over the rising costs of commodities, the average monthly consumption goes only in multiples of these higher denomination currencies. Second, ATM usage also demands feeds in higher denomination.

Despite protection, plastic money is likely to be pushed fast by the Reserve Bank of India (RBI) to increase penetration. If a merchant refuses to accept the debit or credit card and demands additional 3%-5% for its acceptance, there is no law to penalize such merchandise establishments. Likewise, if somebody does not accept the legal tender like a Rs5 denomination note, there is no law by which you can punish them. The latest move of the RBI to siphon out pre-2005 currency would significantly snuff out black money and should be considered the best move in currency management the central bank ever thought of.

There are other areas that get missed out from calculating the gross domestic product (GDP). All the wealth generated by the garbage pickers, waste dealers, scrap dealers, timber transactions and retail jewelers are cash-based transactions. They may or may not have even individual bank accounts. It is unlikely that they will accept cheques. They do not pay any income tax or value added tax (VAT) or service tax. This area generates lot of black money that the country failed to curb for decades.

If the financial inclusion efforts with technology infusion bear fruit and all the villagers are banked, currency management by the central bank and fiscal management by the Central and State governments has tremendous scope to improve.

Incentives for investments

Incentives should come from the growth rather than through the exemptions and fiscal management. There are certain conceptual aspects that need to be kept in mind while discussing tax reforms—incidence and impact of taxes, constitutional obligations; Center-State and State--Sub-State relations vis-a-vis the obligations to citizens towards development and welfare. The other important areas are equity and justice.

One of the fundamental principles of taxation is that it should be progressive at higher income levels and regressive at lower levels. The Direct Tax Code (DTC) takes cognizance of this. It is not unlikely that as the system matures and cash economy gets smaller, the tax rates would be further rationalized from the existing three slabs of 10%, 20% and 30% of the taxable income. All exemptions shall be withdrawn.

Some of the limitations imposed by the Indian Constitution would need to be kept in mind for any tax reforms:

  1. It must not contravene Article 13;
  2. It must not deny equal protection of the laws, must not be discriminatory or arbitrary (Article 14);
  3. It must not constitute an unreasonable restriction upon the right to business (Article 19 (1) (g));
  4. No tax shall be levied on the proceeds of which are specially appropriated in payment of expenses for the promotion or maintenance of any particular religion or religious denominations (Article 27);
  5. A State Legislature or any authority within the State cannot tax the property of the Union (Article 285);
  6. The Union cannot tax the property and income of a State (Article 289)
  7. The power of a State to levy tax on sale or purchase of goods is subject to Article 286;
  8. Save in so far as Parliament may, by law, otherwise provide a State shall not tax the consumption or sale of electricity in the case specified in Art 287;

Payments and settlements

Annual Report 2011-12 of the RBI has this interesting data:

Systemically Important Payment Systems (SIPS) that include Real-time Gross Settlements (RTGS) increased in volumes from 33.2 million in 2009-10 to 55 million in 2011-12—with corresponding value of Rs322.8 lakh crore on and Rs484.9 lakh crore, respectively.

Cheque clearing transactions covered 1400 million in 2009-10 with a value of Rs114 lakh crore and these has remained almost stable in 2011-12.

Electronic clearing significantly moved up between 2009-10 and 2011-12: from 313.7 million to 512.3 million with corresponding values of Rs6 lakh crore and Rs20.6 lakh crore, respectively.

These figures no doubt reveal that the role of technology in circulating high volumes of transactions.

There is enough evidence today that growth led to reduction in poverty. Prof SS Bhalla has proved, in a piece in Inclusion, that during the 21-year period (1984-2005) growth was around 55% and poverty decline was about 2% per annum (in log terms). In the five year period since 2004-05, as the growth increased the pace of poverty decline also more than doubled to 4.7% per annum.

In fact, I would venture to suggest that the best way to reduce imbalance and ensure growth is through increasing share transaction tax from 0.15% to 1% at both the ends. There will be a hue and cry immediately after such increase but the dust would settle down eventually. The philosophy behind is that the buyer sells for a future gain and the seller sells for avoiding immediate loss (a loss of expected surplus). In a way, both are gainers. The tax is paid out of only the surplus. The tax is not going to be regressive just because it is done at both ends of the transaction. It has least administrative and surveillance costs and, on top of it, the tax is collected instantly and made available to the Government for investment in either social expenditure or for addressing the natural calamities concerns. Actually, to this extent even the corporate tax structure can be rationalised in subsequent years. This would help the Fiscal Responsibility Budget Management significantly.

(B Yerram Raju (is an economist and risk management professional)





3 years ago

The authors intentions are appreciated to bring out the point of informed discussions. So considerations of impact on different aspects by Arthakranti is required. So I suggest to go through the website http://www.arthakranti.org and specific topic on blog at http://blog.arthakranti.org/rbis-action-...

Nalin Patel

3 years ago

make bribe giving and taking legal, only through check crossed. deduct TDS on bribe given, let bribes be made income deductible.

all so called five year plans are suggested plans, government need not implement them, let private parties implement suggested five year plans,

issue share certificates for taxes paid to the tax payer, so they will keep watch and demand dividend from tax investments made.

have regressive taxation like in south korea and japan, more you earn lesser you pay the tax, for example if you earn 100 pay 10 as tax and if you earn 500 pay 45 as tax and not 50.

black money shows non confidence of public in government development plans,so work on removing it, why should one not have black money? people will ultimately spend it ,it is only when transaction need approval by masses that white money is used!!! other wise who care after all they both are money and have equal purchasing power.?

there is recession in west, so black money held in west does not give return , so why not make way for bringing back those money give create some way so the same is brought back home and home grows rather than west or tax heaven places.


3 years ago

The author has rightly analysed the prevalent problems in th economy.

Gopalakrishnan T V

3 years ago

The author's suggestions to bring in changes in the taxation system are good. The real problem in the economy is lack of growth which is due to wrong taxation policies disincentivising investments, savings,production and employment. Tax is required in any economy but it cannot have a killer effect. No transaction or no activity is left without tax in the economy as of now affecting the very desire to indulge in any activity. Tax is essential but it should be linked to income and wealth creation and it should not be at the cost of Production, employment growth etc. It should not be inflationary and should help distribution of income in an equitable and justifiable manner. The Concept of transaction tax should emerge as a tool to levy the fees for the Government and it should not pinch the payer too much. This cannot be passed on to any one subsequently. Who ever generates any profit or any income should be taxed and more of such taxes should find place in an economy to keep the inflation under control. The tax on luxuries like purchase of Gold , jewellery, high value commodities like platinum or silver or any luxury items never purchased by an average man should attract more taxes and these cannot be inflationary. The tracking of high value transactions should be made on an ongoing basis and evasion of taxes should be dealt with severely. A lot can be done if there is a will, without affecting the masses and growth of the economy.


Yerram Raju Behara

In Reply to Gopalakrishnan T V 3 years ago

The suggestions are of great value and need active consideration by the Ministry of Finance.

Consumers with cancelled insurance plans shifted to new ones without their permission


When California pharmacist Kevin Kingma received a letter last fall notifying him that his high-deductible health plan was being cancelled because of the Affordable Care Act, he logged into his state’s health insurance exchange and chose another plan beginning Jan. 1.




Here’s what happened to Kingma and others: When they received letters last fall, they were informed that their plans had been cancelled. But within the letter, it also said that if they did nothing, they would be switched over to a different plan and if they had set up their payment to autodraft from their account, it would continue to do so.

Kingma said he didn’t read the whole letter, just enough of it to know his old plan was being cancelled.


Kingma then repeatedly faxed and contacted the insurer through its website. An Anthem representative first told him that he may only receive reimbursement for about half of January, until the date he actually cancelled the new policy. Since then, it appears the insurer cancelled his policy at the end of 2013. But as of Friday afternoon, it hadn’t refunded Kingma’s money, he said.


Darrel Ng, a spokesman for Anthem Blue Cross, said in an email that insurers across California had moved members from cancelled plans to new ones that comply with the law “and that transition retained their payment preference.












Kingma said the whole situation has left him frustrated.




Courtesy: ProPublica.org


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