The National Bank of Denmark (NBD) implemented a comprehensive set of changes to the way it manages its foreign exchange reserves in 2023. These involved adopting a new strategic asset allocation (SAA) to stabilise income over the long term, reinforcing the decision-making process clarifying management and implementation roles, and joining a central clearing counterparty to improve liquidity management. At the same time, market activity changed significantly. Higher interest rates made money-market placements, such as reverse repurchase agreements, more attractive than cash account holdings. These changes also served to anchor the reserves’ decision-making process with the central bank’s top management body. The reserves portfolio plays a critical monetary policy function at the Danish central bank, by defendingthe krone’s peg to the euro (€1 is Dkr7.46038, with a fluctuation band of +/- 2.25%). A 2022 inflationary shock and tighter monetary policies pursued by major central banks, including the European Central Bank, has led to market developments, where more active reserve management is favourable. Thesewere contributing factors behind the NBD reconsidering whether its institutional reserve management setup was sufficiently resilient. From July 2022 until September 2023, the ECB increased its deposit rate at an unprecedented pace, raising it from a record low of -0.5% to the record high of 4% in 2023, where it remains. This coincided with volatile equity and bond markets, which caused hefty mark-to-market and real losses on reserves portfolios worldwide. Nonetheless, the adoption of an asset-liability management setup did not derive directly from market developments. Beyond the specific market conditions, it was aimed primarily to reinforce risk management and stabilise income over the longer term. “We took inspiration from how commercial banks run their asset and liability management,” says Thusjanthan Gunapalasingham, head of reserve and risk management at the NBD. “A key element is how they manage interest rate risk, use their frameworks and track this risk in their modelling.” The NBD decided to find a new balance between the interest rate risk across both the asset and liability sides of its balance sheet. Firstly, the central bank modified duration. “We do not stipulate that the short rate is the risk-free rate,” explains Gunapalasingham. “Our risk-free portfolio has some duration, because we do not look at risk over a one-day or one-year horizon, we look at risk over a longer horizon.” He adds that if duration is short and interest rates rise, the central bank benefits from reinvesting its assets and reaping higher returns. However, if interest rates decline, reinvestments will be placed in a considerably less favourable environment. “Therefore, you need to have some duration in your portfolio that can stabilise your income over a longer period,” says Gunapalasingham.New SAA based on ALM
However, a longer duration also entails income fluctuations as NBD reserves are marked to market. Additionally, the duration on the asset side cannot operate on its own, it needs to match duration on the central bank’s liability side. To do that, the central bank decided to assign a duration to its banknotes and coins, and its capital. These liabilities are non-interest-bearing and can, in theory, be viewed as a zero-coupon liability with a longer maturity.
“As an example, if our investment horizon is five years, we could just invest in five-year bonds when matching assets to the non-interest-bearing parts of liabilities, because our investment horizon is five years. But we cannot do that. You also need to assess how much income volatility you are willing to accept during that period,” says Gunapalasingham. “If we buy a five-year bond when rates go up, you are going to lose money on your asset side. But, on the liability side, this is not going to be reflected because the matched items will appear at par value. This approach can only stabilise the net interest income, not value adjustments.”
Thus, the central bank opted for a mixed solution combining longer bonds with shorter maturities to stabilise income over the investment horizon.
Once the adequate level of income stability is secured, the division deems it has found the ‘minimum risk portfolio’. This only accounts for interest rate risk. To better optimise returns with the same level of risk, the department can add equities or credit spread risk in the portfolio, exploiting asset correlations. But to go beyond the ‘minimum risk portfolio’, it needs to involve the central bank’s board of governors.
New governance framework
The new market environment showed the NBD it needed to update its governance. In the past, risk decisions were linked to one quantitative model to manage risk.
This provided a robust regime. However, the framework was challenged by complexities that cannot possibly be captured by one model. To adapt to the new market environment, the central bank concluded it needed to better anchor strategic risk decisions with the top management. This has better equipped the central bank to set a strategic asset allocation based on a wider set of risk parameters.
The NBD has athree-member board of governors, comprising Per Callesen, Signe Krogstrup and chair Christian Kettel Thomsen. The management group involved in strategic reserve management now includes the three governors, plus the head of departments or directorates.
“Where we need to have discussion with our board of governors, it is about how far they want to move out of the efficient frontier,” says Gunapalasingham. “That becomes a management decision on how much risk you should take over the minimum risk level.”
CCP and liquidity management
The final step in the NBD’s transformation was gaining access to a central counterparty (CCP) platform. The central bank’s commercial partner is Eurex. As with the new SAA and governance structure, higher interest rates and volatility played a role in making this decision.
Traditionally, the Danish central bank held the cash it needed for its FX interventions in the Eurosystem of central banks. “That was a good way for us to keep our portfolio liquid. But now that the ECB has communicated a reduction in the remuneration on these deposits, it is less favourable to hold all cash there,” says Gunapalasingham.
The ECB imposed a 0% interest rate cap on domestic government deposits in 2014, when it resorted to negative interest rates amid below-target inflation and scant liquidity. However, as the governing council started to increase interest rates to tame high inflation in July 2022, the cap became untenable.
In September 2022, to preserve the “effectiveness of monetary policy transmission and safeguard orderly market functioning”, the governing council set the ceiling for the remuneration of government deposits at the deposit facility rate or the euro short-term rate (€STR), whichever was lower.In February 2023, the governing council tweaked the system again. From May 1, the cap has been €STR minus 20 basis points.
“We have a portfolio of $91 billion and a significant portion was in a central bank cash account. Changes of 20–30bp… it’s a lot of money,” adds the NBD official.
In this environment, the central bank concluded there were better options in the market to manage liquidity and safely reap returns.
The Danish central bank had already implemented triparty repo transactions in which one party sends cash, the other offers collateral and an agent is hired to manage the transaction and collateral. Generally, it is a secured way of trading. “But you are quite dependent on the number of specific counterparties,” says Gunapalasingham.
“On the CCP there are more counterparties. We also have the possibility of directly reaching out to CCP members over the Bloomberg chat, like in triparty repos,” he adds. “But we also place trading levels (size and price) where unknown counterparties can ‘hit’ our order during the day, and ‘take’ the market price at any time of the day where the counterparty is also unknown. But at the end of the day, our exposure will only be against the CCP. Overall, the CCP allows for more sophisticated ways to deploy our liquidity during the day.”
For instance, the central bank can find trading partners for operations on specific dates. It can also trade anonymously, or openly with counterparties it already knows.
Regardless of market conditions, the NBD can carry out FX interventions. Its liquidity management framework is designed to provide this capability.
The NBD had done much of its preparation work when it first contacted Eurex about its offering.Conversations started in May 2022 and, in February 2023, the central bank decided to join the platform, which became effective in August.
“That was quite fast by anyone’s standards. They were very structured in their approach,” says Dale Fullilove, sales executive at Eurex.
The NBD had 16 full-time staff members managing Denmark’s close to $91 billion reserves portfolio as of November 2023. This includes strategy, front office, middle office and back office.
During the transition process, “they were always working in two or three different work streams simultaneously”, Fullilove says. “It takes some coordination internally, and usually it needs a project-management approach to onboarding; someone who has an overview of the whole process.”
The overall infrastructure operates in three layers, Eurex repo manages trading, Eurex Clearing is the CCP, and Clearstream banking is in charge of collateral management and settlement.
Eurex’sGC pooling market, where the NBD is active, includes 130 counterparties, and daily traded volumes hover around€40 ($43.8 billion) and€50 billion, single counted.
Another key aspect is that in bilateral or triparty repo transactions counterparties need to secure legal permissions to deal with each other. This is a time-consuming process that can take two years to complete. In contrast, once the NBD secured legal and technical access to Eurex, it automatically obtained permission to trade with all the agents active in the CCP.
“It’s important for us, as a central bank, because if liquidity dries up in one region we can easily move towards something else,” Gunapalasingham says.
The Central Banking Awards 2024 were written by Christopher Jeffery, Daniel Hinge, Dan Hardie, Joasia Popowicz, Ben Margulies, Riley Steward, Jimmy Choi and Blake Evans-Pritchard.
