When there are not enough buyers or sellers for a transaction to happen, such low liquidity incurs a liquidity risk.

A successful trade depends on a simple factor: the existence of buyers and sellers. If you were to try to sell cryptocurrency X at price Y, it may happen that there are no buyers who are willing to buy at price Y. This is a liquidity risk.

Therefore, liquidity risk necessarily requires low liquidity. In the above example, if a trader can't sell cryptocurrency X at price level Y, this means they are engaging in a buyer's market. Consequently, when there are not enough buyers willing to purchase cryptocurrency X at price level Y, they can suppress its price level down, by forcing the seller to go lower.

Vice-versa, if a trader can't buy cryptocurrency X at price level Y, it is a seller's market. Meaning, sellers can keep the price up because the demand is on the side of buyers while the supply is on the side of sellers.

Of course, a liquidity risk may also force the trader to simply wait until a matching buy/sell order happens. On the other hand, if a trader is in a hurry, they would have to significantly discount the asset, resulting in huge losses.

As you can tell, liquidity risk is all about the availability of ask-bid spreads. The wider the spread is, the higher is the likelihood of a liquidity risk popping up. Moreover, there are two types of liquidity risks:

  • Market liquidity risk - Inability to easily exit the market, or asset illiquidity. For example, let's say you buy an NFT (non-fungible token) with an intent to sell it. If no buyers are willing to make the offer, you may end up in a situation where you have to sell it for less than you bought it for, thus suffering a financial loss.

  • Funding liquidity risk - This is the internal illiquidity of companies, i.e., their ability to find their operations on time. Such a risk is calculated by the assets/present liabilities ratio. If it is skewed toward liabilities (debt), the funding liquidity risk will be higher.

In conclusion, a liquidity risk is solvable with more time, to which different investors have different tolerance levels.