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EONIA switches to €STR

Economic Comment


To the dossier 'Benchmark reforms: Bigger than Brexit?'

On 2 October 2019, the ECB started publishing the euro short term rate (€STR). Based on a broader set of data, the €STR rate should provide a more robust measure of overnight funding than EONIA. Daily EONIA fixings –linked to the new €STR rate– will continue to be available until 2 January 2022, but the benchmark is scheduled to be discontinued thereafter. The switch to €STR directly affects contracts that reference EONIA and mature after 2021. Additionally, the new overnight rate may impact valuations of other contracts.

Meet €STR

EONIA has historically been based on interbank transactions. But due to a combination of both structural and temporary factors, the average daily volume of these transactions has declined from EUR 40bn in 2003 to just EUR 4bn in 2018/2019. This has reduced the representativeness of the EONIA index as the European overnight benchmark. 

The euro short term rate is a new measure of overnight unsecured bank funding published by the European Central Bank, designed to replace EONIA. The calculation of €STR is derived from data provided to the ECB through money market statistical reporting, which means that the ECB can base the €STR fixing on data provided by 50 banks, almost double that of the current EONIA panel. Additionally, to ensure sufficient volume underpinning the daily €STR fixing, the ECB decided to not only include interbank transactions, but also bank borrowing from non-bank financial institutions, such as money market funds, investment funds, pension funds and central banks. Transactions with governments and corporates are explicitly excluded from the computation. This sees the volumes underpinning €STR at about 30bn on a daily basis.

Table 1: €STR versus EONIA
Table 1: €STR versus EONIA Source: ECB, EMMI, Rabobank
Figure 1: A substantial spread between €STR and EONIA
Figure 1: A substantial spread between €STR and EONIASource: Bloomberg, ECB

While the inclusion of transactions with non-bank financial counterparties increases the daily volume substantially, it also affects the rate of the €STR benchmark. Data indicates that, compared to the EONIA rate, €STR fixes between 8 and 9 basis points lower every day. This discrepancy is caused by the inclusion of non-bank counterparties: whereas banks have access to the ECB’s deposit facility, these non-bank counterparties do not. This means that the ECB’s deposit rate is an ineffective floor for the €STR rate.[1]

The transition to €STR

Although the €STR benchmark is now available, an immediate changeover to this benchmark was deemed unfeasible. This would risk disrupting existing contracts that currently reference the rate. At the same time, the working group on euro risk free rates wanted to avoid a situation where liquidity would be split between EONIA and €STR.

Therefore, a transition period was created to allow a majority of EONIA contracts to expire as normal, and to allow for sufficient time to repaper the remainder of the contracts. Between October 2019 and December 2021 daily EONIA rates will remain available, but using a different methodology: during this period EONIA will be fixed at €STR +8.5bp. This avoids that the two rates move independently of each other, and should thus allow €STR to benefit from EONIA’s liquidity. Moreover, the cessation of EONIA on 3 January 2022 should provide further incentive to gradually embrace €STR as the preferred reference rate.

So far, the market is still in the early stages of adopting €STR. Liquidity will gradually increase with central counterparties clearing €STR trades. Moreover, central counterparties are expected to switch to €STR discounting in the second quarter of 2020; LCH has stated it plans do so on 22 June 2020. We believe that this should further promote €STR-based trades and help boost €STR liquidity.

Business impact

Any contracts referencing EONIA that mature prior to January 2022 can be expected to mature without any disruption. EONIA has successfully switched to the new methodology, and will remain available through the end of 2021. However, any contracts that mature after 2 January 2022 will be affected by the cessation of EONIA. A large majority of EONIA derivatives should have matured by then, but this change may also affect other types of contracts, such as deposits, current accounts, etc. These contracts may need to be repapered or renegotiated. For new contracts, and especially those with a maturity after December 2021, it is recommended to reference €STR as a benchmark instead.

Moreover, the cessation of EONIA will also have an impact on the European discounting curve. Since €STR is structurally below EONIA by 8.5bp, the €STR based OIS curve will also be lower. Assuming that an €STR-flat discounting convention is adopted across the market, present value computations will be affected: due to the lower discount rate, the discounted value of future cash flows will generally increase. That could lead to accounting gains/losses, and in the case of financial instruments such as EUR swaps, could affect the value of the contract.

[1] These non-bank financial institutions can only deposit their excess cash at a commercial bank. Since these banks do not need the excess liquidity and will have to deposit it at the ECB’s deposit facility, the rate a bank is willing to pay on such deposits is usually slightly below the ECB’s deposit facility rate (currently -50bp). This creates a ‘leaky’ floor, and causes the €STR rate to fix slightly below the ECB’s deposit rate.

To the dossier 'Benchmark reforms: Bigger than Brexit?'

Bas van Geffen
Rabobank KEO

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