What is the liquidity risk in using an Eonia liabilities discounting curve?

liquidity

"It's a bit like the chicken and egg story. Will the liquidity in the Euro OverNight Index Average (Eonia) space start flowing as soon as policy makers in Europe ask pension funds and insurers to use Eonia to discount their liabilities? Or will regulators adopt Eonia for liabilities discounting as soon as liquidity will flow better along the Eonia curve?", wonders one London-based head of Nordic solutions at a global investment bank. Since a handful of pension funds and insurers has shifted its focus towards the Eonia space, this question is in everyone's mind.

Today, some countries in Europe such as Denmark and the Netherlands use a market curve derived from 6-month Euribor swaps as a liability discounting tool. For longer maturities, those countries have determined a last liquidity point on this market curve - set at 20 years - from which they use an artificial rate called the ultimate forward rate (UFR). This was done in prevision of the future implementation of the Solvency II framework for insurers at the European level. However, a few market players have decided to adopt a market curve derived from Eonia instead of 6-month Euribor arguing that the OIS rate remains a more transparent benchmark.

"We do generally consider an OverNight Index Swap (OIS) as a more appropriate reference rate for discounting. For example, high volumes have been traded at Eonia even through the worst period of the financial crisis. This makes Eonia applicable as a reference rate since it is a market rate and it is based on traded prices. However, we would be concerned about the lower liquidity for long-dated OIS swaps", says Morten Hemmingsen, head of equities and fixed income at the Danish pension fund PenSam.

Just like Euribor, Eonia is also based on intra-banks unsecured deposits. The main difference clearly comes from the credit risk associated to each curve. If a bank were to go bankrupt after 4 months under a 6-month Euribor swap, the lender would lose the principal lent plus the interest it is owed. In comparison, under a 6-month Eonia contract, the lender would receive the principal back the day after. But while, Euribor remains the main reference rate for long-dated interest swaps, Eonia constitute the main reference for shorter instruments. This is precisely where the issue lies for long only investors.

That being said, the issue surrounding the lack of liquidity could easily be addressed by regulators across Europe if they were to introduce Eonia as a discounting curve for pension funds and insurers. A bunch of market participants argues that the scandal surrounding the fixing of Libor, and possibly other inter-bank rates such as Euribor, brought up to light in 2011 could encourage the European Commission to opt for an OIS rate as part of the Solvency II framework currently under way. But this does not seem to be the way policy makers look at the issue.

"The liquidity in the Eonia market is still too low. If liquidity was sufficient, the use of an Eonia curve should remove any credit risk connected to the swap market."

In an interview with Risk, Andreas Viljoen, second national expert and policy officer at the European Commission stressed that it will be the European Insurance and Occupational Authority (Eiopa)'s responsibility to define which liabilities discounting curve insurers will be required to use in the future.

"Since the European Parliament and the Council reached a political agreement on November 13 on the transposition and implementation dates of the Solvency II Directive - which will be set for March 31, 2015 and January 1, 2016, respectively - the Commission now has to produce the level two implementing measures. This will take the form of delegated acts. As part of those delegated acts, Eiopa will define and publish its work on the liabilities discounting rates. But the principle is that there should be a deeply liquid and transparent market. So far, the reality is that the 6-month Euribor market is liquid, whereas the Eonia market is not", he says.

The spread between the 6-month Euribor and the 6-month Eonia curves speaks for itself. If we take for instance the 30 year point on the two curves, the current spread remained at between 10 and 15bps by the time the article is being written. If we consider that by using a swap curve, insurers and pension funds will be exposed to fluctuations in the swap spread - which will not necessarily follow the change in their liabilities - then using Eonia could be detrimental from a Solvency II prospective. With Eonia swaps being lower than 6-month Euribor swaps, those institutions discounting their liabilities using Eonia would see their liabilities increase and their solvency ratio drop.

Market participants arguing in favour of Eonia nonetheless believe that since both the Danish and the Dutch regulators decided to adopt the UFR curve last year based on 6-month Euribor, they could also shift to a more transparent benchmark, hence an OIS rate overtime. (Risk Magazine, December 2012, page 35-37) Yet again, Risk received diverging views from at least one local regulator.

Although the Dutch De Nederlandsche Bank (DNB), did not respond to a request for comment by the time this article went to press, the Danish FSA's answer was unambiguous. "This is not something we are working on. It is our assessment that the liquidity in the Eonia market is still too low. If liquidity was sufficient, the use of an Eonia curve should remove any credit risk connected to the swap market. The concept of a risk-free interest rate curve would therefore be clearer than what is currently proposed where an explicit adjustment for credit risk is needed", Jens Henrik Laursen, deputy director of the life-assurance division of the Danish FSA says.

This lack of liquidity has indeed pushed EU regulators to adopt a 10bps spread deduction from the Eonia curve to reach a ‘risk-free curve' under Solvency II. "The question now is whether Eiopa will want to fix this spread for all time or will it want to revisit it from time to time. Nobody knows at the moment what the outcome will be", concedes one London-based head of strategic solutions at a British bank.

In spite of this, a small minority of pension funds and insurers have decided to give Eonia a go. This is the case of the Danish pension fund company, PKA. "6-month Euribor has an inherent credit risk and it is likely to increase in a liquidity crisis as seen in 2008 where the spread between Eonia and Euribor went above 150bps. This in turn will increase the floating rate payments of the swaps to our detriment. As the Eonia rate has almost no credit risk, the floating rates are likely to stay low in a crisis and are likely to be closer to the ECB rates", Jannik Hjelmsted, senior portfolio at PKA says.

Contacted by Risk, Eiopa recognised the issues surrounding Euribor. "There is a general consensus in the sense that interest rates of swaps with fixing IBOR are currently considered by financial markets as reflecting more risk than interest rates swaps with fixing ONIA. Empirical evidence is quite conclusive on this assessment and on its permanent character for the time being", one technical expert at Eiopa concedes.

As level one of the Solvency II framework stands now, investors might be required to use a discounting curve based on 6-month Euribor for euro-denominated liabilities. But nothing is set in stone. Eiopa will determine which curves need to be used for each currency. As for the minor ones for which no discounting curves are available, insurers will need to construct the curves themselves based on the principles Eiopa will set.

The issue here is the volatility of the Eonia swap curve. Although liquidity on the Eonia curve has not been so much of an issue during the crisis as banks were willing to lend on an overnight basis, the situation has now changed. The spread on the Eonia swap curve stood at between 8 and 10bps in the past years for swaps with a 30 year tenor - against 10-15bps now. And there is a concern among lenders that the spread could widen even further as banks have started to pay back long-term refinancing operation (LTRO) facilities the European Central Bank (ECB) put in place in December 2011 to help ease the eurozone crisis. This means that the excess of liquidity the ECB provided in the system is falling.

But what would be the practical issue with adopting an Eonia market curve to discount liabilities? From a market perspective, if regulators were to shift to a Euro OIS, significant amounts of interest rate exposure would potentially need to be moved so the transition period would have to be sufficiently long to limit the market impact.

"The most pronounced consequence would probably be a widening of the Eonia-Euribor basis. This would especially be the case if large institutional investors across Europe were to move to an Eonia discounting within a limited transition period. Hopefully, a long transition period might make it possible to build a supply that can match the increase in demand", Hemmingsen says.

From an investor's point of view, using a market curve derived from 6-month Eonia and still trading 6-month Euribor swaps would lead to a basis risk. According to the Danish FSA, if companies expose themselves to such risk, they should be taken it into account in their internal capital assessment, as planned under solvency II. Market participants nonetheless argue that there is always a basis risk involved somewhere. It all goes down to the question of where this risk should be taken.

The logical approach would then be to trade Eonia swap to match the 6-month Euribor swaps investors still have in place. An Eonia swap is similar to a plain vanilla interest rate swap transaction with the exchange of a fixed rate interest cash flow for a variable rate cash flow or vice-versa just as for an Euribor swap. The floating leg is referenced against Eonia. At inception, Eonia swaps are usually at-the-money and the present values of both cash-flows must equal 0. Upon settlement, only the net cash flows are paid one business day after maturity. But unlike Euribor swaps for which maturity runs between six months and beyond 30 years, eonia swaps historically are a money market instrument and focus on much shorter-dated maturities of between one week, up to two years.

So the question is can Eonia become more active for long-dated swaps used by long-term investors? Eonia beyond two years currently tend to trade as a basis to normal swaps. "In the old days, banks would ignore this basis risk. But since 2008, they are actively managing this exposure to Eonia", says one London-based director of research at an European investment bank.

Although, it is unclear which banks currently trade those basis swaps, it is fair to think that the largest global investment banks are all expected to do so from a pure risk management prospective.

But how does that work in practice? Banks willing to trade long-dated Eonia swaps will have to split them into three different trades. They will first trade via the swap market by using a standard fixed-floating swap versus a 6-month Euribor. They will then overlay a basis swap from the floating rates, one set against 6-month Euribor and the other against 6-month Eonia to convert the cash flow from Euribor to Eonia. According to some market participants, these basis swaps can be traded beyond 30 years.

"We effectively split the kind of Eonia swaps into two components. One is the fixed-floating component and the other one is the floating-floating rate component. One advantage for us in doing so is that the fixed-floating leg is much riskier as it is much more volatile than the floating-floating leg. So if we do a trade with a counterparty, we will always focus on hedging the fixed-floating first since it can move a lot quicker and we would spend more time hedging the floating-floating leg", one London-based trader at a global investment bank explains.

The issue here is the valuation of the basis swap. Eonia will have higher rates than 6-month Euribor due to the extra risk incurred by banks. However, just like straight Euribor swaps, basis swaps will have to be at par at inception. Banks will therefore have to determine a spread their counterparties will pay.

To do so, three curves will be used. Contrary to Euribor swaps, which require a forward curve and a discounting curve, for Eonia swaps + the basis, banks will use: One 6-month Euribor curve, one 3-month Euribor curve and one Eonia curve. The use of a 3-month Euribor curve is due to the fact that banks will have greater access to the liquidity in that market.

"The Eonia curve is the easiest to construct as you can discount with the rates you observe in the market, whereas the 3-month and the 6-month Euribor curves are more difficult to construct since you are discounting using the Eonia curve but calculating cash flows using the 6-month Euribor expectation", the trader goes on to say.

According to data provided by an insurance company, the price for trading a medium size Eonia-Euribor basis swap, say with a €250m as notional principal, would range from 0.3bps to 0.6bps. This cost would obviously need to be added to the 6-month Euribor swaps, long-term investors trade and for which, the price can range from 0.5bps and 0.7bps, according to data provided by the same insurer.

Hemmingsen from PenSam concedes that the long dated Eonia-Euribor basis have cheapened up significantly over the last five years and are almost back to levels before the financial crisis. "The basis could probably cheapen even further. But given the current cheap levels it is an option to be considered", he says.

Yet again, another London-based trader at a global investment bank concedes that a potential liquidity squeeze could arise. "The liquidity issue in that context would arise only if insurers or pension funds tried to unwind those trades. At that point, they would certainly incur a wider bid-offer spread. But there is no reason for them to trade those overlays actively in and out. As long as they can get in at reasonable levels and it really is a position", he says.

That said, banks are no longer the only ones to manage their basis risk. Hedge funds have already moved to OIS discounting, while a handful of pension funds and insurers valuing swaps at mark-to-market, hence those in the Nordics and the Netherlands, are also increasingly exposed to the spread between Euribor and Eonia.

Those investors traditionally pay floating and receive fix payments on a swap. At inception, Euribor swaps are usually at-the-money. However, the EUR Swap curve changes constantly. Over time, as interest rates implied by the curve change and as credit spreads move, those swaps might go in-the-money. This will be true if interest rates fall or stay lower than expected, which has been the case for the past few years. In that case, pension funds and insurers will profit and their counterparties will have to start posting collateral.

That could be the end of the story but here is the trick. Since 2010-2011, more and more insurers and pension funds have been cleaning their CSAs, moving towards single currency agreements - made of euro government bonds and euro as cash. The collateral posted by insurers and pension funds' counterparties for those 6-month Euribor swaps will therefore be discounted using an Eonia curve. (Risk Magazine, March 2011, page 19-23).

"So in effect, if your swap position goes in the money and you receive collateral, you are in a way creating a basis position where you are having a spread narrowing trade between Eonia and Euribor", explains Tom Carstensen, a Copenhagen-based director for the Nordic region within the Financial Institutions Group (FIG) at BlackRock.

This explains why some pension funds and insurers have been trading basis swaps over the past few years and have started to express view on their exposure to Eonia.

Between 2008 and 2009, the spread between 6-month Euribor and 6-month Eonia swaps with a tenor of 30 years widened above 200bps. However, this spread has been narrowing a lot since 2009. Given those movements, some investors are now considering that they could benefit from a spread widening if markets were at stress again in the future and have decided to put in place basis swap spread wideners.

Using a basis swap spread widener would be effectively taking a view that a six-month fixed is going to move higher relative to Eonia. From an investor's prospective, those wideners will somehow appear as another hedging position against a new crisis or market volatility.

PKA started to use basis swap spread wideners back in May-June 2011, a year before it decided to adopt 6-month Eonia as its liabilities discounting curve. So far the Danish pension company has traded with Goldman Sachs, Citi, Morgan Stanley, Deutsche Bank, Barclays and Nordea.

But still, so far, the broad market consensus is that Euribor remains the main reference rate underlying euro interest rate derivatives. "Six-month Euribor still offers enough liquidity on every point along the curve. Obviously, there is difference in terms of liquidity for 30 or 50 years swaps but still enough to go around that", says Max Verheigen, head of trading at the risk management firm Cardano in Amsterdam.

All in all, trading Eonia swaps all goes down to the stance long-only investors might take on the future of the market. From a pure regulatory point of view, if investors want to discount their liabilities with a discounting curve imposed by regulators - so under 6-month Euribor - and hedge their liabilities effectively with Eonia swaps, they would for sure incur a basis risk.

But from an economic prospective, they could also expect to make a positive P&L on the basis risk they would incur if there is another bank liquidity crisis and another spread widening between 6-month Euribor and Eonia.

Another London-based trader at a European bank finally concludes that the main takeaway, as more and more investors move into OIS discounting, is that the liquidity improves, which will help increases the banks' ability to adjust the prices.

However, until policy makers adopt Eonia as a liability discounting curve, not many investors might want to make such a move. And the truth is that, for now, the final outcome on discounting rates remains more uncertain than ever.

In a nutshell, the Commission points out that it will not be able to publish the level two of Solvency II before the next Parliamentary term, sometime in August or September 2014. "The Parliament and the Council will then have to adopt the acts. This process could take up to six months, so they might not be approved before February 2015 at the earliest. Then, from March or April of that year, insurance companies will start working on their internal model approval processes in which they will have to detail which curve they use for discounting their liabilities", Viljoen concludes.

In the meantime, a move into the central clearing space might help bring liquidity in the Eonia space. If we follow the rules banks have applied since 2009-2010 when they started using Eonia for euro cash and government bonds CSAs, the same rationale should apply under the central clearing system. As more and more European investors start posting increased amounts of euro cash and euro government bonds as collateral to comply with the margin rules set under the European Market Infrastructure Regulation (Emir), it will become very clear that all the new derivatives will be valued off an Eonia curve.

"At that point, we might see some of the large investors moving to an Eonia curve. In doing so, they would finally have consistence between the valuation of their derivatives used for duration management, on the one hand, and the discounted value of the liabilities internal capital models on the other hand. Once they will reach this discounting match, they might be willing to move their swaps into the Eonia space, bringing more liquidity into the market", concludes the head of strategic solutions at the British bank.

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