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EURIBOR reforms: Same car, different engine

Economic Comment


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

In July 2019, the FSMA has authorised the continued use of EURIBOR, albeit with an updated calculation methodology. So, opposed to many of the IBORs, the EURIBOR benchmarks will continue to exist for the foreseeable future, meaning that there is no immediate risk of a major disruption for contracts relying on EURIBOR fixings. Nonetheless, contracts should include robust fall-back language to account for the eventuality that EURIBOR is discontinued in the future.

Same car, different engine

In their effort to improve the quality of benchmarks, the European Commission has created Benchmark Regulation (BMR). This regulation entered into force on 1 January 2018, with a transition period until 1 January 2020. In order to increase the transparency and accuracy of benchmarks, this new regulation requires that “the input data shall be transaction data, if available and appropriate.”  By contrast, EURIBOR has traditionally been determined by a daily survey of panel banks. Moreover, these panel banks have been falling in number and geographic diversity, reducing the representativeness and robustness of EURIBOR as a benchmark for the European unsecured money market.

Figure 1: EURIBOR panel banks by country
Figure 1: EURIBOR panel banks by countrySource: EMMI
Figure 2: The number of panel banks has halved
Figure 2: The number of panel banks has halvedSource: EMMI

To comply with the new regulation, the European Money Markets Institute first attempted to update EURIBOR’s methodology to fully rely on actual transactions instead of the daily survey. However, current market conditions did not allow for this. In recent years, there are simply too few transactions in the unsecured interbank market to allow for a robust and reliable daily fixing for the EURIBOR benchmark rates.

Figure 3: Waterfall approach
Figure 3: Waterfall approachSource: EMMI

Therefore, EMMI created a ‘hybrid’ calculation methodology for EURIBOR. This methodology primarily bases EURIBOR on transactions, whenever possible. But a ‘waterfall’ methodology ensures that there are two alternatives if insufficient market data is available. In a nutshell, the first back-up method is a set of formulaic calculation techniques. Should there also be insufficient data to use this calculation methodology, a final step in the waterfall allows the use of other data from sources closely related to the unsecured euro money market. In July 2019, the FSMA granted EMMI authorisation under BMR, which means that EURIBOR can continue to exist for the foreseeable future, albeit with an updated methodology.

No cliff-edge

The continued availability of EURIBOR benchmarks for the 1 week and the 1, 3, 6, and 12 months tenors has reduced the immediate potential impact of a discontinuation event: the risk of a disruption to EURIBOR-linked contracts has subsided.

This also limits the transition efforts required. In fact, the hybrid methodology is already being used. When it applied for authorisation in May 2019, EMMI also announced that it would immediately start phasing in the new calculation methodology: between May and December 2019, the EURIBOR fixings would gradually be moved from being based on the panel survey to the new waterfall methodology.

In terms of fixings, the impact of the new methodology is near-impossible to establish. Since EMMI has let the methodology evolve gradually, it is very difficult to separate the impact of the calculation methodology from changes in the fixing due to developments in the economy or financial markets. That said, since May 2019 volatility in the daily EURIBOR fixing has increased noticeably. Moreover, there is an observable difference in the correlation between the different EURIBOR tenors, meaning that estimates of basis risk may need to be updated. Also note that due to the introduction of the new €STR overnight rate, there could be a valuation impact from a change in the EUR discounting curve

So, with the EURIBOR benchmark remaining available, for EURIBOR users the most important action is contingency planning: ensuring that contracts contain robust fall-back clauses in the case EURIBOR should ever cease to exist in the future.

Future proof?

Indeed, while the authorisation of EURIBOR allows the benchmark to be used for the foreseeable future, we continue to see risks that EURIBOR may be discontinued in the longer-term. The data released by EMMI after their first tests with the hybrid methodology shows that the average volumes are indeed still very low, and concentrated in the shortest tenors. Therefore, we cannot help but think that the decision to authorise EURIBOR was at least partly due to the large number of contracts that depend on EURIBOR, particularly also in the retail (mortgages) sector in certain parts of the Eurozone. This renders a non-disruptive switch to an alternative benchmark very difficult in the available timeframe.

Meanwhile the working group on euro risk free rates continues to investigate whether they can create an €STR-based alternative. For now, the scope of this project is to create a robust fall-back benchmark, in the case EURIBOR should ever become unavailable. But should the working group succeed in creating a reliable alternative, there could come a point in time when €STR-term becomes the de facto replacement.

Figure 4: Few trades underpin hybrid EURIBOR
Figure 4: Few trades underpin hybrid EURIBOR       FIGURE: Fixing mostly relies on the lowest waterfall levelSource: EMMI
Figure 5: Fixing mostly relies on the lowest waterfall level
Figure 5: Fixing mostly relies on the lowest waterfall levelSource: EMMI

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

Bas van Geffen
Rabobank KEO

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