ECB published a report, by private sector working group on euro risk-free rates, which contains recommendations, from a risk management perspective, on the transition to new risk-free rates. The analysis conducted in the report comprises general risk management considerations, risk management implications of transitioning from EONIA to the euro short-term rate (€STR), risk management implications of €STR-based fallback rates for EURIBOR, and certain additional risk management considerations for the asset management and insurance sectors.
The focus of the report is not on the effects of the transition on specific financial instruments but on the overall consequences for interest rate risk management, especially in the implementation phase during the transition period. The key recommendations include the following:
- The working group recommends that market participants set up a well-governed risk-free rates program to identify exposures at risk and develop a transition strategy.
- The market participants are recommended to identify all of the products that are likely to be affected and determine the most appropriate way to amend legacy EONIA contracts, design new business contracts, and make adjustments throughout the transition.
- The working group recommends that market participants use historical time series for EONIA risk factors along the curve as feasible (and best available) proxies for the historical time series of €STR risk factors before October 02, 2019. It is also recommended that market participants communicate with clients in advance to facilitate a smooth transition and include fallback provisions in contracts referencing EONIA, in particular for those maturing after the end of 2021, in accordance with the recommendations on the EONIA to €STR legal action plan.
- Regarding risk reporting and limit systems, the working group recommends market participants to ensure that market risks arising from the new €STR-based products and €STR risk factors are limited. To meet this requirement, additional limits, for example for €STR sensitivities, might be necessary.
- With respect to internal models for the calculation of regulatory own funds requirements for market risk, the working group recommends that banks and relevant ESAs and national competent authorities enter into a discussion with the goal of producing suitable standard interpretations regarding the required analysis and reporting of the model changes for internal models used under Pillar 1 in the context of benchmark transition.
- The working group recommends that market participants gain an overview of the quantity of basis risk exposure from fallbacks in their current EURIBOR-indexed contracts by assessing the exposure amount and estimating the magnitude and volatility range of the spread. It is also recommended that market participants develop a clear plan for current and future hedging instruments and strategies for the relevant basis risks, including associated costs, in addition to setting up corresponding market observations and possible warning indicators for market liquidity in the relevant hedging instruments.
- The working group recommends, with respect to Solvency II, that insurance companies analyze all Solvency II dependencies in the light of the benchmark reform and proactively engage with EIOPA and relevant national competent authorities for clarification about the long-term composition of the EIOPA liabilities discounting curve, going forward.
To ensure that these recommendations are adopted by all market participants, the working group has created a financial accounting and risk management sub-group comprising representatives from European and international credit institutions, consulting and accounting firms, clearing houses, and investment management firms and associations. ECB, ESMA, EC, and Financial Services and Markets Authority (FSMA) all act as observers in the sub-group. The recommendations of the working group are not legally binding. They nevertheless provide guidance for market participants preparing for the transition to risk-free rates.
Keywords: Europe, EU, Banking, Insurance, Securities, Solvency II, €STR, EONIA, Risk-Free Rates, Recommendations, Interest Rate Benchmarks, Interest Rate Risk, ECB, EIOPA
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