In its daily operations as a debt manager, the DSTA faces a number of risks, such as interest rate risk, credit risk, foreign exchange risk, concentration risk, settlement risk, legal risk and operational risk. How the DSTA manages a number of these risks is discussed below.
Image: Outlook 2014
Interest rate risk
One of the aims of the DSTA is to finance the public debt at the lowest possible cost, with an acceptable risk for the budget. The main risk for the budget is interest rate risk, which is the risk that interest costs vary due to fluctuations in the market. This risk is managed by an interest rate risk framework which is revisited periodically, in order to respond to changing circumstances.
The risk for the budget is minimized when the interest rates on the public debt are fixed for as long as possible. In this way the interest costs are as stable and as certain as possible. However, in general, the longer the interest rates are fixed, the higher the interest costs will be. Therefore, a balance has to be found between risk and costs.
In the risk framework for the period 2008-2015 this balance was thought to be optimal when the interest rate was continuously fixed for a seven year period. In order to reach this desired risk, the DSTA used interest rate swaps. In view of the historically low interest rates, it became in 2012 to deviate from what was known as the 7-year benchmark. The deviation implied that the interest rate period of long term state bonds no longer had to be swapped back to 7 years, implying less reliance on interest rate swaps. This caused a gradual increase in the maturity of the portfolio compared to the 7-year benchmark. A more extensive description of the 7-year benchmark and the deviations that were allowed can be found in chapter 4 of the Outlook 2012.
Under the interest rate risk framework for the period 2016-2019 a reassessment of the balance between risk and costs led to a new desired average maturity of the portfolio (debt and swaps) of 6.4 years. This framework was less dependent on interest rate swaps. The average maturity is a measure of the long term interest rate risk. To manage the short term risk an additional measure was introduced: the short term refixing amount. The short term refixing amount reflects the nominal amount of debt and swaps for which interest rates have to be refixed within the next twelve months. For 2016-2019 the short term refixing amount is maximised at 18% of the total public debt. The interest rate risk framework 2016-2019 is described in the chapter 4 of the Outlook 2016.
In 2019 the policy framework for government debt funding, consisting of the funding policy and interest rate risk framework, was evaluated through a policy review. The recommendations following this policy review led to a new interest rate risk framework starting in 2020. Whilst taking into account the current principles of consistency, transparency and liquidity, the relevant market demand and the overall development of the funding need, the issuance of bonds with a longer maturity will have priority from 2020, so as to further extend the average maturity of the portfolio. By further extending the average maturity of the debt and swap portfolio from the current 6.4 years towards 8 years, the current low interest rates will be locked in for a longer period, thereby creating greater budgetary certainty for the medium term. The maximum short term refixing amount will be increased from 18% to 30%, which is consistent with the current, lower level of national debt. Compered to four years ago, the national debt level has declined (both in absolute terms and as a percentage of GDP), allowing for a greater capacity to absorb possible interest rate increases in the short term.
The new policy framework will in principle apply for the next six years (2020 to 2025). In 2026, the framework will be evaluated in its entirety. At the same time, the DSTA will carry out an internal evaluation at least once every two years to allow for adjustments to the policy framework if necessary.
Credit risk is the risk of loss due to a debtor’s non-(re)payment of its contractual obligations. The DSTA is exposed to credit risk when depositing cash with counterparties. To minimize this risk counterparties have to comply with strict requirements regarding their creditworthiness, such as a minimal level of their credit ratings. Furthermore, credit risk is restricted by minimizing uncollateralized deposits and by limiting cash deposits for longer periods. Buy-sell-back transactions (reverse repo’s) are the preferred instrument, since collateral is provided to the DSTA. If a counterparty is not able to fulfill its contractual obligations, the DSTA can use the collateral to cover the loss. In response to the credit crisis, the DSTA decided to strengthening the rules to mitigate credit risk. To illustrate, uncollateralized deposits are only allowed for overnight transactions. The DSTA also engages in transactions with Debt Management Offices from a number of different countries on a regular basis.
When concluding interest rate and foreign exchange swaps, the DSTA is also exposed to credit risk. Therefore, swaps can only be concluded with Primary Dealers and Single Market Specialists that meet minimum requirements of creditworthiness and with whom an ISDA agreement (International Swap & Derivative Association) including a CSA (Credit Support Annex) is signed. During the maturity of a swap transaction, the counterparty is obliged to post collateral with the DSTA if the market value of the swap – which is monitored on a daily basis - is positive for the DSTA. The Dutch State does not post collateral with counterparties.
Concentration risk can be defined as the probability of loss arising from heavily lopsided exposure to one or a small group of counterparties. The DSTA manages concentration risk by setting maximum credit limits on the exposure vis-à-vis individual counterparties. This limit determines how much and by means of which instruments money can be put with a certain counterparty. The limit depends on the creditworthiness and size of the counterparty.
Foreign exchange risk
In addition to issuance in euro, the DSTA also issues in foreign currencies. Commercial Paper is issued in euros, US dollars, British pounds and Swiss francs. In 2012 the DSTA also issued two US dollar denominated bonds.
All issues in foreign currencies are swapped to euros, to safeguard the DSTA against foreign exchange risk. As a result, the funding costs in euros are fixed when the transaction in foreign currency is executed.