The EU benchmark space is getting a bit crowded


The EU benchmark space is getting a bit crowded.

So what are the plans for all these benchmarks jostling for attention?
 
We set out below some of the key changes coming down the line, but the things you should care about most are:

  • Operational hit: Euro Overnight Index Average (EONIA) will be fixed to the euro’s new reference rate (ESTR) +8.5bps from 2 October 2019 with the fixing published T+1…expect some operational headaches bedding this in, but no value transfer in October
  • Legal doc changes: the EU have avoided any immediate legacy legal contract changes by retaining EONIA short term (it will be finally discontinued on 3 Jan 2022), albeit now tied to ESTR; but from now on expect legal contracts to start to reference ESTR not EONIA, and any legacy EONIA contracts will require addition of fallback or rate replacement language to ESTR + spread
  • Move to ESTR flat: at some point (during 2020?) Central counterparty clearing houses (CCPs) will switch discounting curves from EONIA to ESTR flat, triggering a change in collateral valuations facing CCPs, and likely an equivalent move in the bilateral market
  • EURIBOR soldiers on: and what of EURIBOR, the Euro Interbank Offer Rate, which is far more widely referenced than EONIA today? Unlike for GBP LIBOR in UK and USD LIBOR in the US, the death knell has not been ringing so loudly for EURIBOR; it is being reformed to make it EU Benchmark Regulation compliant, but will stay for now with no value transfer observable as result of the reforms so far

Read on below for a more detailed explanation of the expected EU benchmark changes and impacts.



What is happening from October this year? 
 
The EU Working Group is now focusing its efforts on trying to ensure a smooth transition to the euro’s new reference rate, ESTR. After a consultation earlier this year, they made numerous recommendations to European Money Markets Institute (EMMI - EONIA’s administrator) to try and achieve this, including using a recalibration approach whereby the Euro Overnight Index Average (EONIA) would essentially become ESTR plus a spread and run in parallel with ESTR for two years, to give the market time to change over. EMMI also consulted the market about the recommendations and as a result, from 2 October 2019, EONIA’s methodology will change.

It will be calculated as ESTR plus a spread to avoid a valuation change (set at 8.5bp and published by the ECB). As EONIA’s calculation will be based on ESTR, it can only be published after ESTR. So EONIA’s publication date and time will change from 7:00pm CET on day T currently, to 9:15am CET on day T+1. There will be no EONIA published on 1 October. EMMI will cease publication of EONIA from 3 January 2022. ESTR will also be published for the first time on 2 October 2019.

A timeline of key events...

Please click on the timeline to enlarge 


What does this mean from a legal & operational perspective?

 
From a legal perspective, there will be no need to amend contracts before the 2 October 2019, as EONIA will still continue to be published and even though it will have changed its methodology, the addition of the spread means that the economic value intended to be represented in contracts will be unchanged. However it may be wise, from a conduct perspective to include references to the upcoming methodology change in new contracts executed between now and October and the EU Working Group has in fact recommended this.
 
From an operational point of view, systems and processes need to be able to accommodate the change in timing of EONIA’s publication. We expect that settlement dates will stay the same but the change of timing will mean that there will be a shorter window within which to calculate and settle it, as the settlement amount will be calculated on T+1 rather than T.  Market participants need to be mindful of this and ready to make any necessary system changes.

What are the market implications?
 
Minimal, as whilst EONIA essentially becomes ESTR plus a 8.5bp spread, the spread addition is designed to ensure that there is no valuation change in contracts that referenced EONIA previously. The market development for ESTR will be a journey, with CCPs and Venues supporting at different stages with each party letting the market know respective dates.  

What needs to happen between October 2019 and 3 January 2022 when EONIA ends?
 
The short answer is A LOT and unfortunately it is not going to be an easy ride, particularly for legacy transactions. In their Legal Action Plan, the EU Working Group made a number of final recommendations about the transition.

These include:

  1. Ceasing execution of new transactions using EONIA, once ESTR is published from 2 October where feasible and appropriate (we imagine the market will be waiting for liquidity in ESTR to build first). 
  2. If new transactions are executed using EONIA, then embedding fallbacks within those transactions, especially where they mature after 2 January 2022. 
  3. Noting the need for consistency across asset classes where possible, standardising documentary change solutions which can be implemented by the market on a voluntary basis in a timely and consistent manner.  

The EU Working Group has formally recommended that the fallback for EONIA should be ESTR plus the spread. As a result, if parties incorporate the ISDA (International Swaps and Derivatives Association) Benchmark Supplement into their transactions this would be a really quick and easy way to adopt the second of the EU Working Group’s recommendations. This is because this formal recommendation would act as the Alternative Post-Nominated Index within the Supplement ‘path’ of fallbacks, allowing the parties to use ESTR plus the spread if EONIA was permanently discontinued (as it will be).
 
Amending legacy transactions is problematic, ISDA itself has called out the issues with protocols (low-take up, especially the more optionality that is included), and may not want to saturate the market with yet another protocol when the hotly anticipated ISDA IBOR fallbacks protocol (to incorporate the new ISDA 2006 Definitions) will no doubt be top of the agenda for many market participants when it is published late this year/early next. However without a protocol, the market needs to be prepared for a bilateral negotiation amendment process to add the EONIA fallback in or change the references from EONIA to ESTR. Considering the amount of CSAs that currently reference EONIA, this would be a large-scale task.

Pricing / modelling / discounting
 
An added complication can be found in the addition of the spread. Currently EONIA will be published with the spread until its discontinuation. However, what happens after that point? It is feasible that at some point the market will shift to using ESTR flat rather than ESTR plus the spread. This would surely mean a valuation change? 

We understand that there hasn’t been a definitive statement from the CCPs on this yet, but it is crucial that their plans are made known and factored into the transition, otherwise you might have a situation where the bilateral, uncleared market is treated/valued differently compared to the cleared market (and the bilateral, uncleared market will want to follow the cleared!). Will there be a "BIG BANG" approach taken and they switch to ESTR flat at a certain date or will they allow two methods of discounting, one for ESTR flat and one for ESTR plus the spread? The effect on collateral valuation and pricing models needs to be considered and the issues need to be resolved and sharpish.

Decisions about discounting will also have an important impact on liquidity in ESTR swaps; i.e. transitioning regulatory discounting curves away from EURIBOR projected / EONIA discounted to ESTR projected and discounted swap rates. The main industries affected by this element of transition will be the Insurance and Pension sector. 

We understand that there is talk of the CCPs using compensations schemes to ‘soften the blow’ of any valuation changes i.e. a cash payment between parties to account for the difference. Whatever happens the EU Working Group has recommended that the switch be made and that clean discounting is applied (so only one curve is used) which suggests that two methods of discounting remaining after 2022 is highly unlikely.

EURIBOR – the EU reference rate that has been modified but will continue past 2021…for now?
 
Unlike the other IBORs, EURIBOR is not being discontinued, due in part to the reliance of the EU retail mortgage market on the rate. However, work has been carried out to reform its methodology, resulting in a three-level hybrid which uses actual market transactions where possible, in line with regulatory requirements. EMMI has recently been granted authorisation by the Belgian Financial Services and Markets Authority (FSMA) as the critical benchmark administrator for EURIBOR under the EU Benchmark Regulation. ISDA and its members are currently considering whether the phased implementation of the hybrid methodology requires any legal changes. 
 
The EU Working Group’s looking at creating a fallback for EURIBOR that is based on ESTR. They have recommended a methodology based on tradeable Overnight Index Swaps (OIS) quotes for calculated an ESTR-based forward-looking term structure and are now calling for benchmark administrators to express their interest in creating this.

While the EXACT end of LIBOR is unknown and dependant on various 'triggers', what IS certain is the change in EONIA/introduction of ESTR in 60 days’ time, the end of EONIA in January 2022 and the NEED to transition to ESTR in the intervening period. Three certainly is a crowd. 

Glad that's all clear...


Glossary

CCP - Central counterparty clearing houses

EURIBOR stands for Euro Interbank Offer Rate - is a reference rate that is constructed from the average interest rate at which eurozone banks offer unsecured short-term lending on the inter-bank market.

EONIA stands for the Euro Overnight Index Average and is a daily reference rate that expresses the weighted average of unsecured overnight interbank lending in the European Union and the European Free Trade Association (EFTA). It is calculated by the European Central Bank (ECB) based on the loans made by 28 panel banks. 

ESTR – Euro short term rates

EMMI - European Money Markets Institute

IBOR - Inter-Bank Offered Rate

ISDA – International Swaps and Derivatives Association

LIBOR is the London Inter-Bank Offered Rate and is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.


 

This is Non-Independent Research, as defined by the Financial Conduct Authority. This material should be regarded as a marketing communication and may have been produced in conjunction with the NatWest Markets Plc trading desks that trade as principal in the instruments mentioned herein. All data is accurate as of the report date, unless otherwise specified.

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  • MAR Disclaimer
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  • Glossary of definitions
  • Historic Trade ideas log

6th August 2019

Author:

Phil Lloyd
Head of Market Structure &
Regulatory Customer Engagement

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