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IBOR Q&A

IBOR Q&As

 

What are benchmark rates and why are they important?

  • Benchmarks are publicly accessible and regularly updated interest rates that are a useful basis for all kinds of financial contracts.
  • Benchmark rates are widely used by individuals and organisations throughout the economic system. Banks use them when lending to individuals or corporate clients, but they are also used in more complex financial transactions, such as the issuance of securities with variable rates, options, forward contracts and swaps.
  • This means they play a key role in the financial system, the banking system and the economy overall. 

European benchmark rates are currently undergoing significant reforms. For more details see this ECB explainer here.

What is the difference between EONIA and EURIBOR?

  • EONIA, or the Euro Overnight Index Average, is the effective overnight rate for the euro, computed as a weighted average of all overnight unsecured lending transactions in the interbank market, initiated within the euro area by the contributing panel banks.
  • Euribor, or the Euro Interbank Offered Rate, indicates the cost of wholesale funding of credit institutions located in the European Union and European Free Trade Association in the unsecured euro money market, measured and calculated for the 1 week, 1 month, 3 month, 6 month, and 12 month tenors.
  • In short, EONIA reflects the annualized interest for an overnight transaction, while Euribor reflects the annualized interest for five individual maturities (1-week, 1- 3- 6- & 12- month), meaning on any given day, there are five Euribor rates.

Why is the current work focusing on EONIA?

  • The current IBOR reforms in all affected jurisdictions are focusing on replacing the overnight rate, as the new overnight rate will serve (under the current plan) as the basis for establishing each jurisdiction's new term rate.  To use the Eurozone as an example, EONIA is currently in the process of being replaced by €STR, or the Euro Short Term Rate. The ECB will act as the calculation agent for €STR, which will be available on October 2, 2019, although a pre-€STR tracker was made available in early 2017. Once €STR is available and liquidity has been established, the rate could be used to build out the term maturities similar to those found under Euribor (i.e. 1-week, 1-month, etc.), although the work on this aspect of the IBOR reform is still in the early stages and may be amended.

Why can’t we simply switch from EONIA to €STR?

  • While both EONIA and €STR rely on transactions from the overnight unsecured money market segment, there are differences in the data used for their calculation, and they do not typically have the same numerical value. Therefore, any direct or pure succession of EONIA by €STR would result in a change in valuation of transactions and contracts tied to the overnight rate and the need to amend legacy contracts tied to EONIA. However, the correlation and difference between both benchmarks has been relatively stable since the start of 2017; this means that by applying a fixed spread to €STR and calling the result EONIA, the market can basically recreate EONIA without having to change any contracts tied to the rate

Which steps are planned to switch from EONIA to €STR?

  • The switch from EONIA to €STR will take place in two parts. First, the methodology for EONIA will be recalibrated to become dependent on €STR, once €STR is available; this means that after October 2, 2019 (the date of the first €STR publication), the market will transition to EONIA’s new calculation methodology of €STR plus a fixed spread of 8.5 basis points.
  • Second, the market will transition from the €STR-dependent EONIA to €STR flat, which will take place sometime on or before January 3, 2022.

What is involved in the EONIA recalibration?

  • As of October 2, 2019, the current EONIA methodology will be modified to become €STR plus a fixed spread of 8.5 basis points. This spread was determined by the ECB and is based on a simple average of the EONIA-€STR spread between April 17, 2018 and April 16, 2019, with a 15% trimming mechanism, while the recalibration date was set to the first day of €STR’s publication for simplicity reasons. In addition, the publication of EONIA will move from “T” to “T+1”.

What makes €STR a suitable benchmark?

  • EONIA is administered by the private sector via the European Money Markets Institute (EMMI), while €STR will be administrated by the ECB. EONIA currently relies on voluntary input by 28 panel banks, while €STR is built on the daily data submissions of the approximately 50 banks reporting in accordance with the MMSR Regulation. Furthermore, EONIA is a weighted average rate of the submitted contributions; €STR relies on individual transactions rather than on a single contribution per bank. 

Why are fallback rates important? What will be the fallback rate for €STR?

  • Fallback rates serve as insurance against the temporary or permanent cessation of a benchmark rate. Without a fallback to a benchmark rate, a party tied to a contract which references said rate could potentially dispute any action taken in response to the unavailability of referenced benchmark. The fallback for €STR has not yet been determined. 

Who is involved in coordinating this reform process?

  • The reform process is being coordinated in the eurozone by the private sector Working Group on Euro Risk-Free Rates, established by the ECB, the Financial Services and Markets Authority (FSMA), the European Securities and Markets Authority (ESMA), and the European Commission. The working group is make up of 21 credit institutions as voting members, with several broader sub-groups devoted to tackling specific IBOR Reform issues, such as the transition from EONIA to €STR, the creation of a term-€STR as a fallback for Euribor, etc. 

How is Eurex affected by this reform?

  • From an exchange perspective, Eurex’s existing product and service offering is not fundamentally affected by the reform. However, new product launch decisions going forward will be influenced by the outcomes of the reform and the impact it has on the market.
  • Eurex also acts as a central counterparty for all of its exchange and clearing members, and therefore valuation models will be adjusted to cope with the reformed rates.

Will Eurex need to change its product suite?

  • Eurex is committed to enhance its product suite and broaden its STIR offering in order to help the market in the transition process as a result of the IBOR reform. In particular, Exchange Traded Derivatives (ETD) based on the EONIA will be adapted to the reformed rate convention.
  • Also, new products and functionalities are in the pipeline with the aim of easing the transition to the new European Risk-free Rates, such as new money market derivatives and the implementation of inter-product spreads across the STIR suite.