In financial markets, liquidity is as essential as blood in the human body, ensuring smooth operations and seamless transactions. However, when liquidity issues arise, the entire market can fall into disarray, potentially leading to financial crises.

What is Liquidity Risk?

Liquidity risk refers to the uncertainty of future liquidity levels, which manifests in the stock market as difficulties in buying or selling stocks or a significant increase in transaction costs. It represents the uncertainty in asset portfolio value changes when investors liquidate assets to meet future cash needs. Bangia et al. categorize liquidity risk into exogenous and endogenous factors.

The Dangers of Liquidity Risk：

1. The Stock Market Can Fall Into a Vicious Cycle

Liquidity risk exacerbates stock market crises, further worsening their impact. A rise in liquidity risk can lead to a loss of liquidity, causing extreme market volatility, including sharp increases or declines in stock prices.

When stock prices surge, a self-reinforcing effect occurs: more investors buy stocks due to the profit potential, while sellers become scarce, forming a bubble.

When the bubble bursts and prices collapse, investors—particularly small and retail ones—often bear substantial losses.This discourages participation in the stock market, making it difficult to attract new investors.

2. Weakening or Loss of the Stock Market’s Financing and Resource Allocation Functions

High liquidity risk reduces the stock market's attractiveness.Investors prefer a smoothly functioning stock market where they can freely buy and sell under the expectation of returns.Speculators, who rely on short-term trading and price fluctuations, demand high liquidity. If liquidity is insufficient, speculation becomes impractical.

Without active investors and speculators, market expansion stalls, limiting the stock market's ability to support initial public offerings (IPOs) and secondary financing for listed companies. Furthermore, an illiquid market hinders corporate mergers, acquisitions, and restructuring, preventing businesses from scaling efficiently. This, in turn, restricts the capital market’s role in resource allocation and improving social welfare.

3. Liquidity Issues Spill Over Into Other Financial Markets

The financial system is highly interconnected, with economic entities and assets closely linked across financial sub-markets. Liquidity problems in the stock market can trigger liquidity shortages elsewhere due to liquidity-driven effects.

A stock market decline caused by liquidity risk can devalue pledged stocks, reducing financing activity.

This can lead to declines in the futures market and further spill over into the money and credit markets, affecting corporations and banks.

As liquidity risks propagate across financial sub-markets, they can create a severe "liquidity spiral," which, in extreme cases, may result in a financial crisis.

4. Disrupting Monetary Policy Transmission

Capital markets, such as stock exchanges, serve as key channels for the implementation and transmission of monetary policy.

If the stock market lacks liquidity, capital flow is hindered, preventing monetary policy adjustments from effectively influencing stock market expansion or contraction.

Insufficient liquidity also impairs companies' ability to raise funds and affects economic growth.

When liquidity is scarce, stock price movements become less elastic and stable. This weakens the Tobin effect and balance sheet channels, reducing the impact of monetary policy on corporate investments, household wealth, and consumption.

Strategies to Mitigate Liquidity Risk：

1. Strengthening Supervision and Regulation

Regulatory oversight can help prevent drastic fluctuations in stock market liquidity and mitigate extreme market volatility.

Besides improving regulatory frameworks, authorities should focus on cracking down on market manipulation, insider trading, and illicit activities by "black market speculators" and fraudulent financial advisors.

2. Attracting High-Quality Listed Companies

When long-term investors dominate the market, stock prices tend to revert to their intrinsic value rather than being driven by short-term fluctuations.

In contrast, poor-quality listed companies attract speculative traders, leading to unpredictable volatility and low liquidity.

Introducing high-quality companies, including foreign enterprises, into the stock market can increase the supply of high-value stocks, easing liquidity risks.

3. Promoting Institutional Investors and Encouraging Rational Investment

Institutional investors, especially long-term and rational investors, do not base their trading decisions on market rumors.

A higher proportion of such investors stabilizes the stock market, reducing liquidity risks and preventing extreme price swings.

When rational investment practices dominate, the market can develop a stronger investment culture, avoiding synchronized price surges and crashes.

4. Innovating Stock Market Trading Mechanisms

Investor demand in the stock market is diverse, and trading systems must evolve accordingly.Trading orders should allow greater flexibility in terms of pricing and execution timing.

Introducing various order types—such as intraday limit orders, cross-day orders, and weekly orders—can enhance market liquidity.

For busy investors, allowing authorized brokers to execute trades on their behalf at optimal prices can increase order volume and diversity, improving market liquidity and catering to different investor needs.