Determination of a default risk-free discount factor

From what interest rates does an institution have to derive a default risk-free discount factor as referred to in Article 132c (2) CRR, as amended by Regulation (EU) 2019/876 – CRR2?

Article 132c (2) CRR will apply from 28.06.2021. It requires an institution to calculate the exposure value of a minimum value commitment that meets the conditions set out in Article 132c (3) CRR as “the discounted present value of the guaranteed amount using a default risk-free discount factor”. It does not specify any further, when a discount factor is to be considered “default risk-free”. In particular, one may wonder whether interest rates used for deriving “a default risk-free discount factor” should be floored at zero, as the word “discounted” may suggest that the present value of a minimum value commitment should not exceed its notional amount. The following options come to mind: the default risk-free discount factor may have to be derived from ... 1. ... risk-free rates as referred to in Article 325l (2), (3) CRR, this option is the proposed answer. 2. ... the yields for bonds issued by a central government that are denominated in the same currency as the minimum value commitment and that are assigned a risk weight of 0% under Article 114(2) or (4) CRR. 3. ... risk-free rates published by EIOPA On option 2: Under the standardised approach for credit risk a central government bond may be assigned a risk weight of 0% under Article 114(2) or (4) CRR. This means that under the standardised approach such a bond is treated as if it were free of credit risk. If option 2 were adopted, an institution could derive a discount factor e.g. from a yield curve for “all euro area central government bonds”, as published by the European Central Bank (link: https://www.ecb.europa.eu/stats/financial_markets_and_interest_rates/eur... ) and claim this discount factor to be “default risk-free”. Under the IRB approach, an institution may however determine that the probability of default of the issuer of such a bond is larger than zero. Unless collateral brings down the LGD estimate to zero this would imply a risk weight greater than zero. On option 3: EIOPA publishes risk-free rates that insurers use for the valuation of their technical provisions under Solvency II. These risk-free rates are based on swap rates observed in the market. Beyond the “last liquid point” which is currently set at 20 years, the rates are derived by extraprolation. (cf. “Consultation Paper on the Opinion on the 2020 review of Solvency II”, EIOPA-BoS-19/465, 15.10.2019, https://www.eiopa.europa.eu/content/consultation-paper-opinion-2020-revi... , paras 2.19 – 2.22) The extrapolation method ensures that “interest rates converge smoothly to the ultimate forward rate” (ibid. para 2.30). Since end of March 2019 the ultimate forward rate is set at 3.90% for the Euro. (ibid. para 2.34). Inter alia, the last liquid point, the ultimate forward rate and the speed by which the extrapolated rate approaches the ultimate forward rate are currently under review by EIOPA.