The countdown for the world of interbank rates has begun. Two new benchmark rates will emerge: the ESTER rate to replace EONIA in October 2019 and the new Euribor, initially scheduled for no later than 1 January 2020, postponed to 1 January 2022.
The turmoil around the roadmap for the introduction of the new rates, under the responsibility of the European Money Market Institute (EMMI) for Euribor and the European Central Bank for ESTER, as guarantors of methodology and publication, is explained by the importance of EONIA and Euribor in the financial universe. EONIA, which stands for Euro Overnight Index Average, is the weighted average of unsecured overnight transactions; Euribor, Euro Inter Bank Offered Rate, is the average interest rate at which banks lend funds to other banks at different maturities in the eurozone.
On the latter, about 350 billion euros of contracts and debt instruments are indexed to Euribor. A significant amount that led the European Commission, on 25 February, to postpone the entry of the Euribrid for two years to ensure a sustainable transition for the financial world.
Both are calculated on the basis of data provided voluntarily by a sample of European banks. While for EONIA the collected rates refer to actual transactions with daily maturity, Euribor are rates at which funds are offered at longer maturities on the interbank market. Moreover, if EONIA is the benchmark rate for financial products such as ETFs and Repos, Euribor (at various maturities) is the reference for variable rate loans for the retail segment.
In light of the Euribor-manipulation scandals, it emerged a need to review the way in which the Eurozone's key rates are fixed, with more transparent and robust calculation standards than in the past. For this reason, EMMI will retire EONIA this year in favour of the newborn ESTER (Euro Short Term Rate), launched into financial orbit in March 2017 under the name of PRE-ESTER and administered by the European Central Bank, following other central banks in acquiring the role of data provider – the Bank of England for Sonia (BoE), the Bank of Japan for, and the Federal Reserve for SOFR. The Euribor, instead, will remain but with some changes.
In detail, the ESTER expands the sample of banks that will be obliged (hence, no longer on a voluntary basis) to transmit the data necessary for the calculation of the rate. Contingency procedures will be in place to avoid problems stemming from having insufficient data or transaction volumes concentrated in a few banks. The new Euribor, an hybrid form of its predecessor. The computation takes into account the transactions carried out on a daily basis, if available, or within a flexible time range in case of insufficient data. In case of lack of data, the Eurhybrid is computed based on the estimates transmitted by the banks belonging to the panel.
After some preliminary analysis, the PRE-ESTER turns out to be less erratic and lower by 9 basis points on average than the so-called heartbeat EONIA (Fig. 1).
To quantify the impact on the IRS curve of the change in benchmark, we obtained a curve by indexing the variable leg of a Plain Vanilla Fixed-Float IRS to both the EONIA and the PRE-ESTER rates, using the latest data available. The swap forward structures obtained from the two benchmarks show negligible differences: the EONIA-indexed curve is higher at short-term maturities (about 4 basis points in the 1-year node), whereas the gap is eliminated at tenors greater than ten years (Fig. 2).
Methodology aside, the reform will involve the whole spectrum of market agents, a long chain passing through market-makers and end customers. The aspects related to compliance and contracts, as well as to IT systems, are the most vulnerable to the change in rates; risk managers have to face the thorny issue of adapting tools and valuation models to the new benchmark. Finally, with the European BenchMark Regulation (EU BMR) proposed by the European Commission in force from 1 January 2018, a window opened for the technical-legal certification of the candidate benchmark rates - subject to new standards of accuracy and transparency.
We are witnessing a genuine interest rate revolution, where EMMI and the ECB are engaged in a delicate handing over between old and new rates, a crucial passage for the integrity of the Eurosystem financial markets.