Eli5: Liquidity spiral and Liquidity crunch


Went down finance and stocks rabbit hole. These 2 things are what I can’t get out of my head. What are these things actually and how does it work? How do they lead to crash of stock markets?

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I can explain the basic idea of the spiral part:

Assume A and B own shares of the same stock (or other asset), call it stock XYZ. Also, B owes some money to C, because B has lent some extra money from C to invest it for extra profits (to leverage her investments). C did only do that under the condition, that B has some assets (e.g. shares) which are worth say 50% of the lent money. This is because C wants to mitigate the risk that B cannot pay back the money in the future: Whatever happens, at least 50% of the lent money can be payed back by B.

Now A needs some liquidity (for example to pay for the effects of a bad decision, like gambling on junk bonds). To get this liquidity (=cash), A sells some of the aforementioned XYZ shares. This results in the share price dropping.

Now the condition under that C did lend the money to B in the beginning might not be met anymore, since B’s assets (B owns shares of XYZ that just fell in price) are worth less. C now says: “Give back some of the money I have lent to you. Otherwise, the risk is too high for me.” (= B gets margin called by C.) B needs cash/liquidity to pay back the money, so B sells some shares of XYZ. The share price drops further.

…Now another market participant (D) has also some debt and some shares of XYZ. The spiral continues…

In reality, more market participants, more stocks (and other asset classes) can be involved, so that the result can be a full market crash. In particular that can happen, when many market participants make the same gambles as A, and all lose (see the financial crisis 2007/2008).


So why can that happen? Because market participants over leverage to maximize profits, which works well until it doesn’t and then the house of cards falls.