Liquidity and Counterparty Risks Tradeoff in Money Market Networks

We examine how liquidity is exchanged in different types of Colombian money market networks (i.e. secured, unsecured, and central bank’s repo networks). Our examination first measures and analyzes the centralization of money market networks. Afterwards, based on a simple network optimization problem between financial institutions’ mutual distances and number of connections, we examine the tradeoff between liquidity risk and counterparty risk. Empirical evidence suggests that different types of money market networks diverge in their centralization, and in how they balance counterparty risk and liquidity risk. We confirm an inverse and significant relation between counterparty risk and liquidity risk, which differs across markets in an intuitive manner. We find evidence of liquidity cross-underinsurance in secured and unsecured money markets, but they differ in their nature. Central bank’s role in mitigating liquidity risk is also supported by our results.

The series Borradores de Economía is published by the Economic Studies Department at the Banco de la República (Central Bank of Colombia). The works published are provisional, and their authors are fully responsible for the opinions expressed in them, as well as for possible mistakes. The opinions expressed herein are those of the authors and do not necessarily reflect the views of Banco de la República or its Board of Directors.