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The Changing Euro Interest Benchmark Landscape

Background
Major reference interest rates are key to the global financial system.  Given various concerns, banks have become more reluctant to participate voluntarily in benchmark panels and together with declining activity in the underlying market this has undermined confidence in the reliability and robustness of the existing benchmarks.

To ensure benchmarks remain robust a “multiple-rate approach” has been recommended with the objective of:

  • Strengthening existing benchmarks and other reference rates based on unsecured bank funding costs using transaction.
  • Developing alternative, nearly risk-free, reference rates (RFRs).

The key benchmarks for financial contracts in euro are the Euro Interbank Offered Rate (EURIBOR) and the Euro Overnight Index Average (EONIA). From 1st of January 2020 only benchmarks compliant with these new regulations may be used. Currently EONIA and EURIBOR are not compliant with BMR (Benchmark Regulation).  In order to address the above, a private sector working group was established to a) Identify alternative euro RFRs, b) Identify best practices for contract robustness, c) Develop an adoption plan.

Current status
In September 2018 the industry led working group on euro risk free rates recommended the adoption of ESTER (Euro Short Term Rate) as the replacement for EONIA.   With respect to the reform of EURIBOR there is still work ongoing including looking at a hybrid EURIBOR methodology.  This is also separate work being completed on a term structure for ESTER which could be used as an alternative to benchmark to EURIBOR.

It is worth noting that the working group have requested a 2 year extension of the transition period to 1 January 2022.

How will this impact me?

Both the valuation and reference source of any derivative or cash products which are linked to EONIA or EURIBOR could be impacted.  Even if you think you don’t have any EONIA exposure, it is a core component to the valuation of EURIBOR derivatives for risk management purposes and for financial accounting and hedge accounting purposes.  There may also be an impact on debt instruments given they reference EURIBOR.

What is changing?

1.    EONIA to ESTER

ESTER is planned to replace EONIA and has a number of structural differences to EONIA.  EONIA relies on voluntary data input while ESTER will be built on the daily data submissions of the banks. ESTER is based on unsecured overnight borrowing deposit transactions, while EONIA is calculated using unsecured overnight lending transactions.

2.    EURIBOR to EURIBOR (hybrid) or a replacement benchmark rate

This area is less clear and while work is being completed on the EURIBOR hybrid methodology with a view to having it approved by Q2 2019, there is also work being completed on an alternative benchmark such as the term structure for ESTER.  This could result in the adaptation of a new reference rate for businesses as soon as January 2020.

What should I be doing to prepare?

Ensure you are familiar with the changes being proposed and latest developments.  Analyse your current portfolio to identify the impacted population and begin conversations on how best to prepare for the changes.