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I am trying to understand trading liquidity risk $\cdots$ "Trading liquidity risk occurs when an entity is unable to buy or sell a security at the market price due to a temporary inability to find a counterparty to transact on the other side of the trade." I found this definition on the net somewhere on the net.

If this is to hold true, then can I conclude that trading liquidity risk is common with an OTC market where there are no intermediaries like CCP?

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    $\begingroup$ IMHO, CCPs essentially bear credit risk (or counterparty risk) not liquidity risk. Liquidity has to do with the nature of the instruments / the market in which you trade. Voluntarily oversimplifying, instruments that trade on exchanges are simple and standardised (e.g. vanilla options) whereas instruments that trade on OTC markets are more complex and taylor-made (e.g. exotic options), meaning that the latter often generate less interest than the former. Because of this, there is indeed more liquidity risk in OTC markets. $\endgroup$ – Quantuple Sep 26 '16 at 13:21
  • $\begingroup$ @ quantuple, you are right to say that about CCPs, they are buyers to every seller and seller to every buyer.. they accept margins however they are expose to credit or counterparty risk... in an OTC market where there are CCPs, it means traders deal directly with each other... so each party is responsible for looking for their opposite side to transact with. the presence of CCPs reduce counterpaty and credit risk, when there are no CCPs in an OTC transaction buyers and sellers are still exposed to these risk but very high compared to when CCPs are present. $\endgroup$ – user161976 Sep 28 '16 at 21:56
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Market liquidity refers to the ease with which an asset can be traded on the market.

In the financial literature, it is generally assumed that assets have a "fundamental" value that correspond to the discounting expected cashflows of this asset. This is roughly the Efficient Market Hypothesis (EMH). This value should correspond to the "market price", or "display price".

However in the reality, we observe what we call some frictions such as the bid ask spread (we have in reality two prices for an asset not one as in the Walras equilibrium), brokerage fees, transaction taxes and search and delay costs (this correspond to your case).

All these frictions induce costs to investors.

An asset with important transactions costs make it harder to trade this asset (ie decreasing its liquidity). For example an asset that have an important bid ask spread is likely to attract less investors (generally only long terms investors) because it takes times to amortize the bid ask spread.

The more participants there are, the more liquid the market is. Because transactions costs decrease with the number of participants due to competition.

A Central Counterparty Clearing House (CCP), by lowering the counterparty risk, tends to attract investors to the market, henceforth it increases the liquidity (level) of the market. Also, as pointed out by Quantuple standardization plays a role.

However the liquidity risk shouldn't be seen as necessary correlated with the liquidity level.

An Illiquid asset may have less liquidity risk than a liquid asset...

because liquidity risk corresponds to, as usual in finance, an unexpected change in the liquidity level of an asset.

To come back to your question: can I conclude that trading liquidity risk is common with an OTC market where there are no intermediaries like CCP?

  • No because, even it is true that OTC markets are less liquid than regulated market, it does not indicate by itself that unexpected change in liquidity are more common in OTC market.

As a counter-example I would say that in OTC markets, participants know very well other agents, they trust each other (as much as it is possible in finance....) and so it may be unlikely than a participant refuse to buy/sell an asset at the “market price".

Conversely on regulated market, agents don't know one another, they may suspect the other part of the deal of being more informed, so they may be reluctant to trade at the market price.

In finance, it is important not to mix the level of something (liquidity, credit, whatsoever even the price level) and the risk associated.

Final important point:

I do not say that OTC market have less liquidity risk than regulated ones (because I don't know - I just know that they are less liquid), I just say that before to conclude about that you need to find evidences that support your hypothesis, you shouldn't draw hasty conclusions.

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I would say that liquidity risk is not necessarily a characteristic of certain type of market but a relation between the market "quoted" price and expectations of the price that counterparts have in that market. I.e any one would buy (sell) you an asset if the price you are charging (paying) is low (high) enough.

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