Liquidity risk

Market participants measure liquidity risk in two different ways. For dealers, liquidity
refers to the spread between bid and offer prices. The narrower the spread, the
greater the liquidity. For end-users and dealers, liquidity risk refers to an institution’s
ability to meet its cash obligations as they come due.

As an emerging derivative product, credit derivatives have higher bid/offer spreads
than other derivatives, and therefore lower liquidity. The wider spreads available in
credit derivatives offer dealers profit opportunities which have largely been competed
away in financial derivatives. These larger profit opportunities in credit derivatives
explain why a number of institutions currently are, or plan to become, dealers.
Nevertheless, the credit derivatives market, like many cash credit instruments, has
limited depth, creating exposure to liquidity risks. Dealers need access to markets
to hedge their portfolio of exposures, especially in situations in which a counterparty
that provides an offset for an existing position defaults. The counterparty’s default
could suddenly give rise to an unhedged exposure which, because of poor liquidity,
the dealer may not be able to offset in a cost-effective manner. Like financial
derivatives, credit and market risks are interconnected; credit risks becomes market
risk, and vice versa.

Both dealers and end-users of credit derivatives should incorporate the impact of
these scenarios into regular liquidity planning and monitoring systems. Cash flow
projections should consider all significant sources and uses of cash and collateral. A
contingency funding plan should address the impact of any early termination agreements
or collateral/margin arrangements.