The time pressured transition to alternative risk-free rates.
On 1 January 2020 EURIBOR and EONIA will no longer be compliant with the EU Benchmark Regulation (EU BMR). LIBOR will be sustained by the Financial Conduct Authority (FCA) only until 2021. The question in focus is: Can alternative risk free rates be established to replace existing Inter-bank offer-rates (IBORs) in that short period, and can banks handle the transition in time?
Initiatives to develop alternative benchmarks have been taken on by supranational committees, central banks and representatives of the banking sector. In preparation of the event that an IBOR benchmark is permanently discontinued, the International Swaps and Derivatives Association (ISDA) launched a market wide consultation1 on benchmark fallbacks for derivative contracts. The result of the consultation, which is scheduled to end on 13 October 2018, will determine how the 2006 ISDA definitions will be amended to account for the termination of a benchmark. The main scope of this consultation form GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW rates.
The ECB working group on euro risk free rates2 was inaugurated on 26 February 2018. This industry-led working group was established to identify and recommend risk-free rates that could serve as a basis for an alternative to current benchmarks used in a variety of financial instruments and contracts in the euro area. After discussing three risk-free rate candidates and consulting the market, on 13 September 2018 the group announced its recommendation that the Euro short-term rate (ESTER) should be used as the risk-free rate for the euro area. ESTER is a rate which will be calculated and published by ECB. It is based entirely on actual individual transactions in euro that are reported by banks in accordance with the ECB’s money market statistical reporting (MMSR). The calculation is in line with the international stand-ards set by the International Organization of Securities Commissions (IOSCO) on financial benchmarks.
The ECB working group is now exploring further possible approaches for ensuring a smooth transition from EONIA to ESTER. Sub working groups are asking whether a market for derivatives based on ESTER can be established, thereby building a term structure, and what transition paths from EONIA to ESTER might look like.
The challenges of creating alternative benchmarks and their corresponding markets within the next 15 months - and for banks to successfully adapt their processes and systems - are enormous. The difficulty of addressing the full legal and operational complexities within that timeframe, and market concerns that the remaining time to transition to ESTER is insufficient, were two key topics reported by the ECB work-ing group. Therefore the ECB working group planned to send a letter to the European Commission (EC) for an extension of the benchmark regulation for critical benchmarks3.
However, the EC has indicated that extending the transition period for continued use of current (non-authorised) EONIA and, possibly, EURIBOR benchmarks beyond 1 January 2020 could only be consid-ered as a legislative option if the request was clear, had a high level of stakeholder support and was accompanied by evidence that a smooth transition would be impossible within the initial timeframe. A more detailed implementation plan will shed more light on this last option, and it is expected to be published by the relevant ECB sub working group in the coming weeks.
In the meantime, and until clearer regulatory guidance is provided, firms need to review the transition plans carefully and ensure their risk-free rate programs have the flexibility to adapt quickly to different EONIA scenarios. Supervisory bodies have already begun asking firms for information on their awareness and implementation status. For example, the PRA and FCA have written CEO letters4 to seek assur-ance that senior managers and boards understand the risks associated with this transition, and that their firms are taking appropriate action now so they can transition to alternative rates before the end of 2021.
The recent remarks made by Benoît Cœuré5, Member of the Executive Board of the ECB, that “Financial market participants, on their part, should redouble their efforts to ensure a smooth transition” and by Cornelia Holthausen6, ECB Deputy Director General of Market Operations, saying “I do feel that many banks are pretty complacent and they think the public sector will solve the issue for them”, show the con-cerns for a scenario where the transition fails and EONIA/EURIBOR become non-compliant. Given these statements, banks under supervision of the ECB should assume that a letter challenging their prepared-ness for the IBOR reform is on its way.
The challenge on making the transition in time is on. Let’s get to work.
4Dear CEO Letter, Financial Conduct Authority (PDF 276 KB)