Why are benchmark rates so important?
21 September 2017 (updated on 22 March 2019)
Interest rate benchmarks play a key role in the financial system, the banking system and the economy. They are used by a variety of agents, ranging from banks that provide credit to businesses and households to derivatives market-makers. There are three main reasons that make interest rate benchmarks essential to the smooth functioning of the financial market. First, as a reference in contracts indexed to variable interest rates: the use of reference rates to price financial contracts reduces their complexity and facilitates standardisation. Second, such benchmarks are widely used to value balance sheet items. For instance, they can be used as discount rates for some financial instruments, or in valuations for accounting purposes. Third, they are widely used by the derivatives markets in products such as swaps, options and forward contracts.
The European Commission has estimated, for instance, that the euro interbank offered rate (EURIBOR) underpins contracts with a nominal value of about €180 trillion. Most of these contracts are interest rate swaps, in which a fixed rate of interest is exchanged for a floating rate. But such contracts also include retail mortgages or floating rate issuances (loans, bonds).
Benchmarks are also important for central banks. Monetary policy is transmitted through financial markets and benchmark rates play a pivotal role in the operationalisation and monitoring of the transmission of the ECB’s monetary policy.
The most widely used benchmarks for contracts in euro are EURIBOR and euro overnight index average (EONIA). They are based on the unsecured interbank market. EURIBOR is a quote-based interest rate benchmark, available for several maturities (one and two weeks, and one, two, three, six, nine and twelve months – the two-week, two-month and nine-month maturities will be discontinued as of 3 December 2018). EONIA is the overnight reference rate for the euro, computed on the basis of real transactions in the interbank market, with the ECB acting as calculation agent for the administrator.
- What reforms are taking place in these benchmark rates and why?
EONIA and EURIBOR have been undergoing in-depth reforms under the lead of their administrator, the European Money Markets Institute (EMMI), a non-profit association based in Brussels. These reforms aimed to bring both benchmarks into compliance with the new EU Benchmarks Regulation (BMR), which was published in 2016 and came into force in January 2018. Following a transition period, the requirements of the BMR will become fully binding as of January 2020.
On EURIBOR, over the past few years EMMI has been developing a plan to gradually reform the existing benchmark in order to anchor it to transactions instead of quotes. The feasibility of such a transaction-based methodology was tested by EMMI in the course of 2016-17. However, it was concluded in May 2017 that “under the current market conditions it would not be feasible to evolve the current EURIBOR methodology to a fully transaction-based methodology following a seamless transition path”. Consequently, EMMI decided to explore the feasibility of a hybrid model where the methodology is supported by transactions whenever available, and relies on other related market pricing sources when necessary. A task force was created to gather market participants’ feedback and guidance on the new methodology. In the course of 2019 the Belgian Financial Services and Markets Authority (FSMA), the authority responsible for supervising EURIBOR, will assess whether the new methodology complies with the BMR. In any case, EURIBOR users will need to embed fallbacks to improve the robustness of their contracts, as required by the BMR.
On EONIA, after having concluded the first phase of the EONIA review, which consisted in defining a governance framework compliant with the new regulatory requirements, EMMI carried out the second phase of the EONIA review, namely an analysis of the market underpinning EONIA. In February 2018 EMMI concluded that “should market conditions and dynamics remain unchanged, EONIA’s compliance with the EU BMR by January 2020 cannot be warranted, as long as its definition and calculation methodology remain in its current format. In this context, EMMI’s governing bodies have decided that pursuing a thorough EONIA review is no longer appropriate.” Hence, as it stands, EONIA will not meet the criteria of the BMR, and will therefore see its use restricted as of 1 January 2020.
Both benchmarks rely on the voluntary contributions of two distinct panels of banks, the number of which has fallen sharply in recent years. In order to counter this vulnerability, the BMR provides for a backstop mechanism to safeguard the stability of the EURIBOR and EONIA panels. In practice, this means that the regulator of these benchmarks, the FSMA, may now make contributions to these panels mandatory, subject to specific conditions. Any mandatory contributions, however, would be limited to a maximum period of two years and therefore are not a permanent solution for the continuity of these benchmarks.
- How are benchmark rates for the euro currently calculated?
The main euro interest rate benchmarks, EURIBOR and EONIA, are produced by the European Money Markets Institute (EMMI).
EURIBOR is a benchmark giving an indication of the average rate at which banks lend unsecured funding in the euro interbank market for a given period. The benchmark is calculated daily by EMMI on the basis of the quotes of a panel of banks from the EU (currently 20) contributing on a voluntary basis. It is published every day at 11:00 CET.
EONIA is a reference rate based on real transactions. It is computed as a weighted average of all overnight unsecured lending interbank transactions of the panel banks (currently 28) and published by 19:00 CET on a given day. The ECB acts as the calculation agent for EONIA on behalf of its administrator, EMMI. This means that the ECB compiles the daily contributions of the banks from the EONIA panel and communicates the final rate to EMMI. This arrangement dates from the time of the creation of the euro. It was seen as a way to guarantee the confidentiality of contributions for the panel banks. In addition, it was conceived as a way for the ECB to provide technical support to the development of the euro money market.
- What is the precise role of the ECB in these benchmark rates currently and in euro benchmark reform in general?
The ECB’s involvement in the topic of benchmarks extends beyond its purely technical role as calculation agent for EONIA.
In September 2017 the ECB committed to providing, by October 2019 at the latest, the euro short-term rate (€STR), a euro unsecured overnight rate reflecting wholesale borrowing costs of euro area banks. Furthermore, the ECB launched, together with the Belgian Financial Services and Markets Authority (FSMA), the European Securities and Markets Authority (ESMA) and the European Commission, the industry-led working group on euro risk-free rates and provides the secretariat for this group. The working group’s main tasks are to identify and recommend alternative euro risk-free rates and transition paths.
Regarding EURIBOR, over the last few years, the ECB has also sometimes played a role as a catalyst and supported initiatives for its reform. In particular, it provided technical support to the EURIBOR administrator, EMMI, for the first feasibility studies of a transaction-based EURIBOR methodology in 2013 and 2014. This ad hoc support was aimed at promoting avenues for reform, as the EURIBOR reform was getting underway.
Finally, as a member of the Financial Stability Board (FSB), the ECB has been following up on the interest rate benchmark reforms via a dedicated FSB sub-group (Official Sector Steering Group). In this context, the ECB is monitoring, together with other European authorities, progress made on the benchmark reforms in Europe and occasionally providing guidance on the topic.
- Do we still need benchmark rates now that banks rely less on the interbank market for their funding?
Benchmark rates are essential as they are an integral part of a functioning market. The widespread use of EONIA, which is a purely interbank rate, reflects the fact that, for a long time, the interbank market was perceived as the appropriate market on which to base a useful (i.e. meaningful, usable and robust) benchmark.
However, banks no longer rely on interbank funding as much as they used to and they have other sources of funding beyond the interbank market or the unsecured market which could be taken into account in the calculation of a benchmark. Additionally, very short maturities such as the overnight maturity still generate enough turnover for the construction of robust benchmarks. The new euro short-term rate (€STR) to be produced by the ECB is a response to these developments, as it takes into account not only interbank transactions but also transactions with other entities, such as money market funds, insurance companies and other financial corporations.
- Why will it take two years to develop the €STR? What are the challenges?
Developing a benchmark is a complex process and entails much more than a simple calculation, as the experience of other central banks has shown.
First, a benchmark should relate to a clearly articulated underlying interest, i.e. the economic reality which the benchmark intends to measure. To achieve this, transparent and broad communication with the public, involving public consultations, is necessary to gain insights into user needs. For the €STR, a first public consultation was held from November 2017 to January 2018, followed by a second public consultation held from March to April 2018.
Second, a calculation methodology needs to be selected after in-depth study of the underlying data in order to capture the economic reality as accurately as possible. The methodology for the €STR was published in June 2018.
A technical infrastructure is also necessary to ensure the impartiality of the calculation, the auditability of the process and of course the daily availability of the benchmark.
Finally, for the rate to be sufficiently robust, some time is needed for the testing phase and production. The roles and responsibilities of all parties involved must be clearly assigned to ensure transparency and accountability. Consistency with the internationally recognised IOSCO principles for financial benchmarks will be sought whenever relevant, i.e. taking into account that these principles are not always relevant for a benchmark produced by a public institution. The ECB is committed to providing the €STR by October 2019 at the latest.
- The €STR has been recommended by the working group of euro risk-free rates as the euro risk-free rate. What does this mean?
In September 2018 the working group on euro risk-free rates recommended the €STR as the euro risk-free rate. In particular, it recommended the €STR as a replacement for EONIA, which will not be brought into compliance with the BMR and will therefore see its use restricted as of 1 January 2020. The working group is now tasked with evaluating ways to transition smoothly from EONIA to the €STR. The working group is also tasked with identifying alternative term rates based on the €STR that could be used as a fallback for EURIBOR.
- Will the ECB continue to be the calculation agent for EONIA?
The ECB will remain the calculation agent for EONIA for as long as the benchmark is critical for financial markets and the ECB’s involvement is essential for the continuity of the index.