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Euro risk free rate transition

Euro risk free rate transition

The European Central Bank has recently conducted a public consultation on the assessment of candidate euro risk-free rates.

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The Working Group on euro risk free rates will use the market feedback as input into its recommendation on the new euro risk-free rate.

With EONIA set to be non-compliant with the EU Benchmark Regulation and questions over the future viability of EUR LIBOR and EURIBOR, the clock is ticking on determining an alternative euro risk free rate as a replacement.

EURIBOR and EONIA are currently used in a wide range of financial contracts from derivatives to loans to debt securities. The current market exposure to EURIBOR and EONIA is €124tn and €37tn respectively. As these rates are used by the majority of European market participants and in some retail customer products, the shift to a new euro risk free rate could cause significant market upheaval.

Product Current Exposure
  EURIBOR EONIA
Unsecured Money Market   €0.1tn
Secured Money Market €1.9tn €0.4tn
OIS    €10.9tn
Loans (general) €9.7tn   
Syndicated loans €1.2tn   
Floating rate bonds €0.57tn   
Derivatives €109tn €22tn
Debt Securities €1.62tn €4.4tn
TOTAL  €124tn €37tn

Source: ECB Risk Free Rate Working Group papers

The majority of the current exposure is set to mature in the next 18 months, however in January 2020, there will still be approximately €65.6tn of outstanding EURIBOR and €8.8tn of outstanding EONIA contracts.

The levels of exposure to EONIA and EURIBOR highlight the importance of the euro risk free rate transition. Banks, Asset Managers and Corporates will need to ensure that they have appropriate plans in place for managing their EONIA/EURIBOR exposure and transitioning over to a new risk free rate.

In the consultation paper, the ECB have selected three final euro risk free rate candidates:

  • ESTER (The Euro Short Term Rate) is a new unsecured wholesale overnight borrowing rate administered by the ECB, expected to be produced by October 2019. 
    • Average Daily Volume = €29.8bn
    • Standard deviation of day to day changes = 0.6bps
  • GC Pooling Deferred is the effective secured interbank rate, administered by STOXX, of all Euro one-day transactions in the GC Pooling ECB and ECB Extended baskets. 
    • Average Daily Volume = €6.9bn
    • Standard deviation of day to day changes = 3.8bps
  • RepoFunds Rate is a one-day secured rate, administered by NEX Data Services Limited, which measures the effective cost of one-day funding of general and specific sovereign government bonds in the euro area. 
    • Average Daily Volume = €200.6bn
    • Standard deviation of day to day changes = 14.4bps

Source: First public consultation by the ECB working group on euro risk-free rates on the assessment of candidate euro risk-free rates.

The majority of the market appears to favour ESTER as the choice for euro risk free rate. The rate is formed under a comparable methodology to SONIA and has similar properties to EONIA. ESTER will therefore be easier to understand for most market participants and if chosen should ensure a smoother transition for end users.

A handful of participants favour the RepoFunds Rate due to its underlying volumes and the fact it is a live regulated benchmark. However, the volatility of the rate, particularly at quarter and year end, makes the rate less representative of a true risk free rate.

The GC Pooling Deferred rate has volumes which are similar to EONIA. Unless there is a significant increase in underlying volume, GC Pooling Deferred is unlikely to be chosen as the euro risk free rate.

The publication of ESTER is expected by October 2019 but the exact timing is uncertain. If ESTER is chosen as the preferred euro risk free rate, there could be far less time for the related markets to develop and liquidity to grow. Unless more clarity is provided over the timing for EONIA and future glide paths of EONIA and EURIBOR, market participants may decide that the RepoFunds Rate makes for a better choice.

To help enable a successful transition over to a new risk free rate, time is required to allow the development of sufficient liquidity in the derivatives and cash markets. Firms will need to ensure they maintain flexibility, have full oversight over their EONIA/EURIBOR exposures and communicate effectively with their clients about the potential changes.

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