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The future of Euro risk-free rates

The future of Euro risk-free rates

There are encouraging signs of movement in the reform of Euro interbank offer rates. Even so, timings and replacement rates remain highly uncertain. The next few months should provide greater clarity over the future of Euro risk-free rates. In the meantime, banks need to monitor the situation closely and do all they can to prepare for what is certain to be an extremely demanding transition.

A credible mechanism for calculating inter-bank rates is critical to effective, functioning capital markets. That’s why historic failures and abuses of this process called for a reform of the interbank offer rates and why the EU Benchmark Regulation (BMR) was put in place. However, time pressure and a lack of clarity over replacement rates continue to dominate debate over the transition from EONIA and EURIBOR to a BMR compliant risk-free rate.

In theory, change is coming soon. The EONIA overnight rate and the EURIBOR rates calculated by the European Money Markets Institute (EMMI) for key tenors such as one week, three months and twelve months, will become non-compliant with the BMR on 1 January 2020.

In reality, the scheduled withdrawal of EONIA and EURIBOR rates has not yet stimulated a comprehensive response from market participants. In February 2018 the ECB therefore launched a Working Group on Euro risk free rates. The goal of this industry-led body is to identify replacements for EONIA and EURIBOR.

In September, the Working Group recommended that a new Euro short term rate (ESTER) calculated and published by the ECB using reported transactions, should replace EONIA.

Does that mean the problem is solved? Sadly not.

  • To begin with, ESTER is not scheduled to be published until October 2019, just three months before the existing rates are due to be withdrawn. That is not a timetable that many banks are likely to be able to achieve.
  • Furthermore, things are even less clear regarding EURIBOR's replacement. One possibility is that EMMI might develop a new way to calculate EURIBOR from real transactions rather than quotes from market participants. Another is that, once ESTER is published, market makers will begin using derivatives to build a 'term structure' based on this new rate.

This situation means that the European authorities have received two requests to ease the transition process. One asks to extend the BMR deadline by two years, bringing it in line with the UK's withdrawal of support for LIBOR at the end of 2021. The other asks for ESTER (and possibly an ESTER-based term structure) to be designated as critical benchmarks, signalling their status as successors of EONIA and EURIBOR to the market.

The ECB's round table on euro risk-free rates on 9 November made it clear that industry participants are hoping that EMMI's approach will emerge as 'Plan A' for solving the EURIBOR question. That was hardly surprising, given that this represents the least disruptive outcome in terms of changes to existing processes and contracts. A hybrid approach could see this 'Plan A' supported by a fall-back 'Plan B' of a new term structure.

Once again though, there are catches.

  • First, an extension to the BMR's timeline could be hard to achieve. The European Commission's policy of not tabling any new legislation before the Parliamentary elections of May 2019 means that a delay would need to occur via one of two pending legislative proposals - perhaps as part of the proposed amendments over low carbon benchmarks.
  • Second, the 'Plan A' currently being proposed by the Working Group would require ESMA to authorise EMMI's approach as being compliant with the BMR. Again, that can't be taken for granted.

So where does this leave the banks, which remain deeply uncertain about which rates they will need to be using, and when?

The short answer is that, even if an extension to the implementation of BMR is looking increasingly possible, this certainly cannot be counted on.

The longer answer is that, if an extension were to occur, this should be viewed as a valuable opportunity - not a licence to relax. Prior experience shows that this kind of transition can be exceptionally demanding. Changing IBORs affects every aspect of a bank's value chain including contracts, pricing and valuation, risk modelling, risk management, technology, accounting, financial performance and regulatory reporting.

It follows that banks need to prepare their data, systems, processes and staff for change and engage actively with regulators, clients and other stakeholders - while they still have time.

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