Quick definition A liquidity crisis occurs when buyers and sellers vanish, spreads widen dramatically, and you cannot execute trades at reasonable prices. What it is In normal markets, bid-ask spreads are tight and volume is plentiful. In a liquidity crisis, spreads widen 10x or more and volume disappears. You might want to sell 1,000 shares but can only sell 100 at a time. Liquidity crises often accompany market crashes (people panicking, dealers withdrawing). Why it matters Liquidity crises amplify losses. You want to exit a losing position but must accept terrible prices. This forces larger losses. Liquidity crises are also contagious. Illiquidity in one market spreads to others as traders hit all available venues. Causes Liquidity crises occur when: - Market makers withdraw (fear, capital constraints) - Counterparty concerns (will I get paid?) - Systemic stress (everyone is selling) - Technical issues (market halts) Historical examples 2008 financial crisis saw liquidity crises in money markets and credit markets. 2020 March COVID crash saw temporary liquidity crises. Recovery Liquidity crises are often resolved by central bank intervention (providing cash, guaranteeing counterparties) or by market stabilisation as panic subsides. See also - Market Freeze - Bid-Ask Spread - Dealer Withdrawal - Fire Sale
