European Benchmark Transition Faces Hurdle

Shanny Basar

The low volume of cleared swaps based on Eonia, the euro overnight index average rate, may make it difficult to transition to a new risk-free interest rate based on actual transactions as required by regulators.

Chris Barnes at derivatives analytics provider Clarus Financial Technology said on the firm’s blog: “The number of cleared Eonia swaps is surprisingly low, suggesting a transaction-based methodology will be ruled out.”

Barnes added: “A quote-based system is most likely, but this could replicate existing problems we have with Euribor.”

After the financial crisis there were a series of scandals regarding banks manipulating their submissions for setting interest rate benchmarks, including Libor and Euribor, which led to a lack of confidence and threatened participation in the related markets. As a result, regulators want to move to risk-free reference rates which are based on market transactions, so they are harder to manipulate and more representative of the market.

In September last year the European Union selected Ester, the euro short-term rate, as an alternative euro risk-free rate and replacement for Eonia. Ester reflects the wholesale euro unsecured overnight borrowing costs of euro area banks but has not yet been published. The European Central Bank is due to produce Ester by October 2019 at the latest.

Barnes noted there are many mortgages across Europe linked to Euribor.

“Whilst there are efforts to reform Euribor to make it compliant, it is possible that both Eonia and Euribor disappear at some point,” he added. “The mortgage link brings a retail aspect to the impact of Libor reform and risk-free rates that is largely missing for the US and UK.”

In addition the impact could differ from country to country amongst banks in the region.

ECB consultation

Last month the European Central Bank’s working group on euro risk-free rates, launched a consultation to identify and recommend alternative risk-free rates and transition paths from Eonia to Ester.

The working group was established last year by the ECB, the Financial Services and Markets Authority, the European Securities and Markets Authority and the European Commission. The ECB consultation, which ends on 1 February 2019, proposes three methodologies based on over-the-counter derivatives and one using futures data to produce Ester.

Clarus data showed there were an average of two spot starting 1-month Eonia trades cleared at LCH per day and 13 spot and forward starting 3-month trades between July 2017 and June 2018.

Barnes said: “I was shocked at the tiny number of transactions. Unfortunately, it points towards the fact that any forward-looking term rate fixing will be quote based.”

The Deloitte Centre for Regulatory Strategy said outstanding interest rate derivative instruments referencing Eonia and Euribor are valued at €22 ($25.4) trillion and €109 trillion respectively. A further €4.4bn and €1.6 trillion of interest debt securities are linked to Eonia and Euribor.

Regulatory review

The consultancy said in its Regulatory Outlook for 2019 that these benchmarks are not currently compliant with the EU benchmarks regulation.

“Without compliance, firms will not be able to use these benchmarks in new contracts from 1 January 2020 when EU benchmarks regulation transitional provisions expire,” added Deloitte. “Use in legacy contracts may be permitted by the Competent Authority. The deadline also applies to other non-compliant benchmarks, including third-country benchmarks.”

The report continued that supervisors will review firms’ plans for Eonia and Euribor transition.

“2019 will see firms make real progress in benchmark transition against a backdrop of uncertainty, with major issues such as term risk free rates still outstanding,” added Deloitte. “It is likely to be one of the biggest transformation projects firms will have undertaken, affecting almost every business unit, with huge financial and operational implications.”

In the UK regulators have already written to large banks and insurers to ensure they identify a senior manager with responsibility for oversight of transition programmes and that the board has approved a review of risks relating to Libor transition.

“In 2019, they will continue to question firms on their financial exposures and management of conduct risks,” said Deloitte. “Supervisors will also turn their attention to the next tier of firms, and to buyside firms.”

In addition, Deloitte warned that firms that continue to use “vulnerable” benchmarks in new contracts which mature past 2020 and 2021 may be increasing their conduct risk and the potential for mis-selling claims.

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