Liquidity Risk and Other Non-Market Risks › Historical Liquidity Crises

Understanding liquidity risk requires studying its manifestations in real markets. Several historical episodes illustrate how liquidity can evaporate precisely when it is most needed.

LTCM was a hedge fund that employed highly leveraged convergence trades, betting that spreads between related securities would narrow. With $4 billion in equity supporting $125 billion in assets and off-balance-sheet derivative positions with notional values exceeding $1 trillion, LTCM's leverage ratios were extreme.

When Russia defaulted on its debt in August 1998, global investors fled to safety, widening the spreads LTCM was betting would narrow. As losses mounted, LTCM faced margin calls it could not meet. Worse, the firm's positions were so large that any attempt to unwind would devastate already-stressed markets. Other market participants, aware of LTCM's distress, pulled back liquidity precisely when LTCM needed it most.

The Federal Reserve organized a private-sector bailout, with 14 banks contributing $3.6 billion to prevent a disorderly collapse that could have triggered systemic contagion. LTCM's demise illustrated how leverage, concentrated positions, and liquidity risk can combine catastrophically.

The 2008 crisis demonstrated liquidity risk on a systemic scale. It revealed the dangers of what economists call "liquidity illusion": assets that appear liquid under normal conditions but become impossible to trade during stress.

Mortgage-backed securities and collateralized debt obligations, which had traded with reasonable spreads before the crisis, became essentially untradeable. Banks that had relied on short-term wholesale funding found creditors unwilling to roll over loans. Money market funds, considered safe havens, "broke the buck" when they could not liquidate holdings at par. The Federal Reserve and Treasury intervened with unprecedented programs to provide liquidity that private markets had withdrawn.

When redemption requests exceed available liquidity, funds may suspend redemptions entirely, a practice called "gating." During the 2008 crisis, numerous hedge funds gated investors, preventing withdrawals even as portfolio values plummeted. More recently, several UK property funds suspended redemptions in 2016 following the Brexit referendum, and multiple credit funds gated during the March 2020 COVID-19 market panic.

Gating protects remaining investors from the forced-sale losses that would occur if the fund liquidated holdings at distressed prices. However, it violates investors' liquidity expectations and can trigger panic elsewhere as investors rush to withdraw from similar funds before gates are imposed.