Understanding Liquidity Gap

5 mins read

Liquidity Gap – Introducing the Scenarios in Which They Arise

Financial markets have over the past few decades expanded in leaps and bounds and presently house a wide range of financial securities. These securities are governed by the rules of demand and supply which also play a major role in the workings of the financial markets. However, there exist situations wherein there may arise a discrepancy between the demand or supply for a given security. It is in this very situation that the term liquidity gap gains credence. This article seeks to shed light on the term liquidity gap’s meaning and explores the scenarios in which it arises.

Liquidity Gap – Definition

The term liquidity gap finds itself mentioned in a number of financial situations and is used to refer to a mismatch in the maturity dates of securities as well as in scenarios of discrepancies arising between the demand or supply for a given security. Banks are often exposed to and need to deal with liquidity risks as well as potential liquidity gaps owing to which they need to ensure that they have sufficient amounts of cash on hand at all times such that they can fulfil their customers’ requests for funds.

In scenarios wherein the maturities applicable to assets and liabilities aren’t aligned or in the event that there exists a greater than anticipated demand for funds, the bank may find itself experiencing a shortage of cash. Simply put, the bank then experiences a liquidity gap.

Understanding the Mechanisms of a Liquidity Gap

Apart from banks, firms may also find themselves experiencing a liquidity gap in the event that they lack the cash on hand that is required to fulfil operational needs. Further, they can find that their assets and liabilities may mature at different points in time. Liquidity gaps may also arise in markets in scenarios wherein there exist an inadequate number of investors who can take on the opposite side of a trade. If this happens to be the case, those wishing to sell their securities may be unable to do so.

In the case of banks, a liquidity gap may alter over the course of a day owing to the fact that a string of deposits and withdrawals may be made during this time. This implies that the liquidity gap here provides a quick snapshot of their risk rather than a figure that may be needed to be worked on over a longer time frame. In order to draw comparisons between periods of time, banks often discern what the marginal gap amounts to. This gap refers to the difference that exists between gaps of different time frames.

When taking a look at the global financial crisis of 2008, a number of bond and structured product investors began to notice that they were unable to sell their investments. There existed a liquidity gap which meant that there weren’t interested parties that were amenable to taking on the other side of the trade. Simply put, there were no takers willing to purchase the securities at their reduced price points. Owing to this absence of liquidity, markets operating within some securities began to dry for a number of weeks.

Exploring a Liquidity Gap with the Aid of an Example

In order to understand the workings of a liquidity gap with greater ease, consider the following example that pertains to hedge fund XYZ. This hedge fund purchased mortgage-backed securities (or MBSs) worth INR 500 crores during a time when the housing market was strong. They did so under the impression that the assets they purchased would provide them with a steady flow of income for the foreseeable future. Their actions were also governed by the impression that if they ever needed to sell the MBSs they purchased, they would be able to do so with ease as the liquidity within the markets is ample. They also believe that there existed sufficiently large trading volume for these MBSs and that there existed a number of buyers and sellers involved in these transactions on a daily basis.

However, as time passes, the economy begins to take a downturn owing to the intense monsoons which destroyed crops along with several important shipping ports. These disasters led to several job losses owing to which individuals became unable to pay their mortgages within the stipulated time frames which in turn led to defaulted home loans.

Since payments weren’t made on said home loans which served as the MBS’s underlying assets the MBS’s in turn began to default which meant that they were no longer a source of a steady stream of income. The values associated with mortgage-backed securities, therefore, began to dip. The hedge fund then decided to sell its portfolios of these securities which are now worth INR 270 crores as opposed to INR 500 crores resulting in a loss worth INR 230 crores.

Now, hedge fund XYZ was only able to sell INR 160 crores worth of its portfolio and was unable to find buyers to procure the remainder of its MBS holdings. It, therefore, decided to try to sell this particular portfolio at a discount however it was unable to attract buyers as the housing market is crashing and there are no indicators as to when it will stop and whether or not the value of the mortgage-backed securities will continue to dip some more. This scenario showcases the liquidity gap experienced by hedge fund XYZ wherein it holds a portfolio of assets that it seeks to sell but lacks the buyers needed to sell it to.

Wrapping Up

Liquidity gaps can plague any situation and aren’t exclusive to any one particular scenario. Owing to this very fact it Is recommended to hold more assets rather than liabilities as they allow for greater levels of growth and flexibility and provide their holders with a more well-rounded financial position.