Liquidity risk is the risk that you won't be able to sell an asset, or more generally unwind a trade, for an amount of cash close to its expected value at any given moment. So which assets carry the most liquidity risk? As a general rule, the greatest liquidity risk comes from assets in thinly traded markets. That is, the fewer times an asset is traded on any given day, the greater the liquidity risk. For example, stock in Coca Cola carries much less liquidity risk than a Victorian mansion for the simple reason that Coca Cola stock is heavily traded every business day all over the world. As a result, Coca Cola stock trades can be executed quickly through intermediaries who are willing to buy it from or sell it to you, since these intermediaries know that at some point in the near future, someone else will show up at their door asking to buy or sell some more. So these market-makers must be the greatest people on the Earth, willing to devote their time to make markets liquid, all for the greater good of humanity, right? No. You bought your lunch, even if you don't remember paying for it. In exchange for providing liquidity, market-makers get to pocket the difference between the prices at which they buy and sell.

A swap is a very common type of OTC derivative, which includes that destroyer of economies, the credit default swap (CDS). While industry folk commonly speak of a buy-side and a sell-side to the swap market, you can't really buy or sell a swap in the classic sense, since a swap is an instrument in which both sides have obligations to perform in the future. That is, if the underlying rate moves against either party, that party will have to pay up, much like a future or forward contract. This is in contrast to an option from the perspective of its holder. An option grants the right, not the obligation, to the option holder to buy a particular asset; and creates an obligation on the part of the option writer to sell that asset. You can sell a right and assume an obligation. You cannot sell an obligation. Well, there are probably a few bozos out there. But in any case, both parties to a swap could end up having an obligation to pay at some point in the future.

The Sell-Side

Swap dealers are market-makers for swaps: the sell-side of the market. But how do they create markets when you can't really buy or sell a swap? At all times except execution, swaps have positive value to one of the parties to the swap and negative value to the other. At execution, the market value of the swap to each side of the swap is zero. This is because the price of the swap will be based upon the value of some rate at execution. One party will be long on the rate (benefiting if the rate goes up) and the other will be short on the rate (benefiting if the rate goes down). After execution, that rate will move, up or down, which will create value to one of the parties. What swap dealers do to net their positions is offset their long positions with short positions; and offset their short positions with long positions. In reality, this process is not so simple. The face value of each trade, known as the notional amount, is not likely to match up so perfectly with the other trades, despite being executed by masters of the universe. As a result, they have to work pretty hard to make all of their trades match up.