There has been a new focus on market liquidity in the last year. Will bid-ask spreads increase? Will there be a shortage of liquidity so prices will move away from fair value when you want to execute? Will there be liquidity crises through swift downdrafts in price? All of these liquidity issues are important for investors, but they may not be the most important liquidity issues. There are more macro liquidity risks which can be more onerous and far-ranging.
There is a distinction between macro and micro liquidity risks. Macro liquidity risks are associated with an asset class or broad set of markets and minimize the ability of investors to get out at any price. This could be regulatory restrictions on any sale. Micro liquidity risks are associated with the inability to get an immediate transaction done.
Macro liquidity risk will come from regulatory changes or financial repression that limits the ability to trade. The restrictions on large shareholders ability to sell in China is a simple example.It is not a function of price. The transaction cannot be done. Capital controls would be a macro liquidity restriction. Circuit breakers and price limits are other examples. In the credit markets, bankruptcy and defaults which lead to restructuring will the ability of bondholders to receive principal. These restrictive rules are a part of finance. The risk is when it is unknown when these restrictions will be imposed. If you buy a liquid asset today, you don't know whether there will be future restrictions on your ability to sell in the future. If there is that risk, you may not buy the asset in the first place or at least ask for by return.
Micro liquidity risk is associated with transactional immediacy. A flash crash, a widening of the bid-ask spread, and the lack of trading volume all affect the ability to get a price that will equal fair value. A transaction can occur, but the difference between price and value is unclear.
2016 is already becoming a year of macro liquidity risks. Focal points are the China equity and foreign exchange markets, but we are seeing more regulators focus on macro liquidity as a means of controlling downside risks that cannot be managed through current monetary and fiscal policies. The movement to macro prudential policies may impose macro liquidity risks on investors. This is not always bad, but it will cause a reaction by investors who will not hold risky assets that may be subject to these liquidity issues. The law of unintended consequences lives!