Meaning
Sequential asset liquidations occur when declining prices trigger margin calls or redemptions across multiple portfolios. The onset of liquidity cascades can turn a minor market correction into a full scale financial crisis. It represents a feedback loop where selling leads to lower prices, which in turn forces more selling.
Market Contagion
Price drops in one sector often force investors to sell their most liquid assets in another sector to raise cash. During liquidity cascades, the normal correlations between different types of investments break down as everything is sold at once. This mechanism drains the available cash from the system and stops the normal flow of credit.
Asset Valuation
Forced sales happen without regard for the underlying value of the security or the long term prospects of the issuer. Liquidity cascades create a gap between the price a seller can get and the price a buyer is willing to pay. This readiness question for fund managers involves keeping enough cash on hand to survive such a sudden withdrawal of market depth.
Recovery Period
Stability returns only when the forced selling stops and buyers feel confident enough to enter the market again. The boundary of liquidity cascades is often reached only after a massive intervention by a central bank or a clearing house. Calculating the cost of calling a market bottom early is a primary task for risk officers during a period of high volatility.
