Interest rate benchmarks: what are the developments?
Highlights
- Interest rate benchmarks - also known as base rates, benchmark rates or reference rates are used worldwide for example:
- to determine the prices of financial contracts, such as (personal) loans, mortgages and deposits, and of financial instruments, such as derivatives and bonds; and
- for the valuation of financial contracts and financial instruments.
- Interest rate benchmarks must be robust and reliable. This demands the reforming of the existing interest rate benchmarks in order to increase the objectivity. The reforms also consist of revising existing methods for the calculation of interest rate benchmarks, such as LIBOR and EURIBOR, which will be based more on transactions. Or the replacement of an interest rate benchmark by another - possibly new - benchmark, as is the case for EONIA, which will cease to exist as of 2022 and will be replaced by the new benchmark €STR. This market shift towards risk-free rates has been going on for some time under the influence of European regulations and international standards; the reforms are now being implemented under the supervision of European and national supervisors.
- Banks are preparing for the transition to new benchmarks and the development of alternative benchmarks (fallbacks), in the event that a benchmark ceases to exist in the future. Banks are carefully examining in which processes and products interest rate benchmarks are used and how long the terms are of these products. Each bank must make a plan specifying what the bank must do in the event that a benchmark used by the bank ceases to exist. The Dutch Authority for the Financial Markets (AFM) supervises these plans.
Frequently Asked Questions
The ECB decided to develop a Euro short-term rate, €STR, as an alternative for EONIA. €STR is calculated by the ECB based on transactions that banks report to the ECB daily in connection with the money market statistical reporting (MMSR). The European Working group on risk-free rates has recommended that market parties gradually replace EONIA by €STR. The ECB will start publishing €STR daily as of 2 October 2019.
Following the manipulations of the interest rate benchmark LIBOR, international standards were developed to improve the manner in which financial benchmarks are calculated. In Europe, the international standards were incorporated into the European Benchmark Regulation. The rules aim to make the benchmarks less sensitive to manipulation. For instance, benchmarks must be calculated more based on transactions and less on estimates (quotes) of banks. This makes benchmarks more robust. In addition, supervision of benchmark administrators and benchmark users has been introduced.
Due to various developments, such as the repurchase of bonds by the European Central Bank and the tightening of the liquidity requirements for banks, the number of transactions in the money market has decreased causing the representativeness of some benchmarks to come under pressure. Therefore, hybrid methods have been developed whereby benchmarks are based on a combination of transactions in the market and quotes of banks.
EONIA is the Euro Overnight Index Average, the weighted average of unsecured overnight interbank lending in the European Union. The administrator of EONIA, EMMI, has announced that EONIA will cease to exists as of 31 December 2021 because there are insufficient representative transactions in the longer term on which to base a robust benchmark. EONIA will be replaced by €STR, the Euro Short-Term Rate. €STR is calculated and published by the European Central Bank (ECB) based on transactions that banks report daily to the ECB. The ECB will start publishing €STR daily at 8:00 am CET as of 2 October 2019. As from 2 October 2019 until EONIA is replaced by €STR as of 1 January 2022, EONIA will be calculated based on €STR + a spread. The ECB has set the spread at 0.085% (8.5 basis points). EONIA continues to represent the rate for overnight interbank lending in the eurozone. However, the calculation method will be revised.
EURIBOR is the Euro Interbank Offered Rate, which reflects the lending costs for banks on the unsecured money market. The administrator of EURIBOR, EMMI, has started with the transition to a new method for the calculation of EURIBOR. It is expected that this will be completed by the end of 2019. Under the new hybrid method, EURIBOR will be is calculated based on a combination of transactions in the market and quotes of banks.
EMMI announced that the calculation of EURIBOR will be based on available transactions of panel banks and other sources as far as necessary, such as estimated funding cost of panel banks. Transactions and counterparties that qualify are expanded to reflect the wholesale funding sources of banks. This is clarified in the definitions. EMMI states that EURIBOR has always measured the lending costs for banks for wholesale funding on the unsecured money market. EMMI is of the opinion that the new calculation of EURIBOR does not constitute a substantial change of the underlying interest rate.
As the administrator of EURIBOR, EMMI received a licence from the Belgian supervisor on 2 July 2019. That the EMMI received a licence as administrator of the EURIBOR benchmark confirms that it satisfies all the requirements of the European Benchmark Regulation, therefore the benchmark can also be used after 1 January 2020. As EURIBOR satisfies the European Benchmark Regulation it has been added to the European ESMA register.
LIBOR is the London Interbank Offered Rate, which reflects the lending costs for banks on the unsecured money market for various currencies such as the pound sterling, US dollar and Japanese yen. The administrator of LIBOR, ICE, already changed the LIBOR calculation method and received a licence from the British supervisor in 2018. However, British, American and Japanese supervisors are preparing for a transition from LIBOR to other reference rates. This was underlined by the announcement of the British supervisor that it will no longer oblige banks after 2021 to participate in the panel of banks that are involved in the determination of LIBOR.