The trade-off between liquidity risk and counterparty risk in money market networks

Carlos León and Miguel Sarmiento

Abstract

We examine how liquidity is exchanged in different types of Colombian money market networks (ie, secured, unsecured and the central bank’s repurchase networks) as registered in the local financial market infrastructure. Our examination first measures and analyzes the centralization of money market networks. Then, based on a simple network optimization problem between financial institutions’ mutual distances and the number of connections, we examine the trade-off 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 relationship between counterparty risk and liquidity risk, which differs across markets. We find evidence of liquidity cross-underinsurance in secured and unsecured money markets, although the level differs between the two markets. The central bank’s role in mitigating liquidity risk is supported by our results. Overall, our results provide insights into the relationship between the money market’s structure and financial stability while highlighting the informational content of data in financial market infrastructures.