What are benchmark rates, why are they important and why are they being reformed?
11 July 2019
What are benchmark rates?
Interest rate benchmarks – also known as reference rates or just benchmark rates – are regularly updated interest rates that are publicly accessible. They are a useful basis for all kinds of financial contracts such as mortgages, bank overdrafts, and other more complex financial transactions.
Benchmark rates are calculated by an independent body, most often to reflect the cost of borrowing money in different markets. For example, they might reflect how much it costs for banks to borrow from each other. Alternatively they might reflect how much it costs banks to obtain funds from other sources, such as pension funds, insurance companies and money market funds.
This means that these benchmark rates play a key role in the financial system, the banking system and the economy overall. But what is it exactly that makes them so important? And why are they currently undergoing reforms?
Why are benchmark rates important?
They are widely used across our economy
Benchmark rates are widely used by individuals and organisations throughout the economic system.
For example, banks use them when lending to individuals or corporate clients.
A bank might agree to lend money to a company at an agreed interest rate that is set at a particular benchmark rate plus 2% – meaning that the company would pay interest of 2% more than the current benchmark rate. So, the cost of the loan goes up if the benchmark rate goes up, and the cost of the loan goes down if the benchmark rate drops. In this case, the benchmark can be a reliable, independent, and relatively simple reference for all involved.
Companies, banks and other organisations also use benchmark rates to value items on their balance sheets – in other words these rates make it easier for an accountant to work out how much organisations (more specifically the financial assets that they own) are ultimately worth.
Benchmark rates are also used in more complex financial transactions, such as the issuance of securities with variable rates, options, forward contracts and swaps.
For instance, take an interest rate swap – in very broad terms it is a transaction involving two parties, where each agrees to cover the other’s interest payments. In swaps like these, the benchmark rate may determine at least one of the interest rates being exchanged. This creates transparency for all parties involved, brings some standardisation to the agreement and, as a result, makes it easier for all parties to negotiate.
Other uses of benchmark rates include (but are not limited to): the calculation of overdraft penalties on cash accounts, the calculation of interest on some retail deposits, and the agreement of interest on retail mortgages and loans.
Benchmark rates help central banks to do their job
Benchmark rates can also inform the work done by central banks. We at the ECB, for example, can refer to benchmark rates in our work to keep prices stable in the euro area.
If a benchmark rate properly reflects the rates at which banks lend and borrow, it can help us better understand the functioning of financial markets and the availability of money in the euro area. This can inform monetary policy decisions: if you know how easy it is for banks to access money, you can estimate how readily those same banks will be able to pass that money on in the form of loans to businesses and people. And all of this ultimately feeds into price levels.
Also, knowing the current benchmark rates enables us to monitor the practical impact of our monetary policy decisions. If the ECB decides to raise or lower interest rates, for example, we can track the effects of this by looking out for changes in benchmark rates for the euro.
Why are benchmark rates undergoing reforms and what exactly does this entail?
Benchmark rates are useful as long as they are considered reliable and unbiased – ideally they should be calculated in a transparent manner, and the rates should be easily and publicly accessible. If a contract is based on a reliable benchmark rate, neither party can influence the agreed rate of interest. This means that a dependable benchmark rate can ensure that the value of a contract remains impartial and indisputable.
Given the economic importance of benchmark rates, it is critical that their reliability is ensured by clear governance structures and transparent methodologies.
With this in mind, European benchmark rates are currently undergoing significant reforms. Much of this reform process is driven by the introduction of the EU Benchmarks Regulation (BMR), which was published in 2016 and came into force in January 2018.
The currently most widely used European benchmark rates
This is the current overnight benchmark rate for the euro. A private sector working group on risk-free rates has recommended that market participants gradually replace EONIA with the new euro short-term rate (€STR) as of 2 October 2019.
EURIBOR is an unsecured market benchmark rate calculated for several maturities (one week, and one, three, six and twelve months). It is administered by the European Money Markets Institute (EMMI). In order to bring the benchmark into compliance with the EU Benchmark Regulation (BMR), the EMMI has clarified the definition of EURIBOR as the rate at which banks in the EU and European Free Trade Association (EFTA) could obtain funds in the wholesale unsecured market. The EMMI is also gradually implementing a new calculation methodology for EURIBOR – the so called “hybrid methodology”. This calculation method makes use of actual transactions as much as possible, while also using expert judgement for the cases where actual transactions are not available.
In 2017 the ECB decided to develop the euro short-term rate (€STR) – a new benchmark that will be available as of 2 October 2019 – with the intention that it could function as a backstop in case the private sector fails to sustain its own overnight benchmark rate, EONIA.
In 2018 a private-sector working group on euro risk-free rates recommended replacing EONIA with the €STR, taking into account feedback from the market. This working group is now supporting the market with the transition to the €STR – the ECB provides the secretariat for the working group, and attends as an observer together with the other founding institutions, the European Securities and Markets Authority (ESMA), the European Commission and the Belgian Financial Services and Markets Authority (FSMA).
The €STR in more detail
The €STR is designed to reflect how much a bank must pay when borrowing money overnight from various financial counterparties without providing collateral (this is sometimes referred to as ‘unsecured’). These counterparties can include banks, money market funds, investment or pension funds and other financial actors, including central banks.
This means it has a wider scope than EONIA, which only looks at trades between banks. Furthermore – compared to EONIA – the data on real transactions, used by the ECB to calculate the €STR, are provided by a larger number of banks. This increased scope protects against manipulation, and helps to make the €STR a dependable reflection of the price at which money is borrowed on an unsecured basis across the euro area.
For more details, you can read the euro short-term rate (€STR) methodology and policies published in June 2018. You can also refer to the relevant set of questions and answers.