21 September 2017
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 tenors (one and two weeks, one, two, three, six, nine and twelve months). 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.
EONIA and EURIBOR have been undergoing in-depth reforms under the lead of their administrator, the European Money Markets Institute (EMMI), a non-profit-making association based in Brussels. These reforms aim to bring both benchmarks into compliance with the new EU Regulation on Benchmarks, which was published in 2016 and will come into force in January 2018.
On EURIBOR, EMMI has been developing over the past few years a plan to gradually reform the existing EURIBOR 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 last year. 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 new Task Force has been created to gather market participants’ feedback and guidance on the new methodology.
On EONIA, EMMI announced that it concluded the first phase of the EONIA review, which consisted in defining a governance framework compliant with the new regulatory requirements. EMMI has now undertaken the second phase of the EONIA review, which relates to the analysis of the market underpinning EONIA, to ensure that the benchmark’s design is adapted to the economic reality it intends to capture.
However, 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 EU Regulation on Benchmarks 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 Belgian Financial Services and Markets Authority (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.
The main euro interest rate benchmarks, EURIBOR and EONIA, are produced by the European Money Markets Institute (EMMI).
EURIBOR (Euro Interbank Offered Rate) 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.
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 and published by 19:00 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 (currently 28 banks) 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.
The ECB’s involvement in the topic of benchmarks extends beyond its purely technical role as calculation agent for EONIA.
As a member of the Financial Stability Board (FSB), the ECB has been following up on the interest rates 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. The ECB has also often hosted market discussions and received feedback on the topic via its Money Market Contact Group (MMCG), whose members are professionals involved in euro area money markets. Over the last few years, the ECB has also sometimes played a role as a catalyst and supported initiatives for the reform of EURIBOR. 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, while the EURIBOR reform was getting underway.
The ECB decided to publish an overnight benchmark because of the potential adverse impact on the transmission mechanism of monetary policy and the repercussions for financial stability that could result from the absence of a reliable private benchmark.
However, the ECB is not in a position to provide longer-term reference rates (i.e. beyond the overnight maturity). To judge by the results of the pre-live verification exercise of EMMI and also by the data provided under the ECB regulation on money market statistical reporting (MMSR), it appears that currently there are not enough transactions to construct purely transaction-based longer-tenor reference rates. This means that some expert judgement may be required in order to sustain daily benchmark publications on such tenors. Such judgement cannot come from a central bank for two main reasons. First, the central bank may not have the same overview of the prevailing market conditions and the funding costs of banks as credit institutions have. Second, expert judgement, if provided by a central bank, might be interpreted as being related to the (desired) monetary policy stance; this might create, or be perceived as creating, a conflict of interest.
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, shows that the interbank market is still perceived as the appropriate market on which to base a useful (i.e. meaningful, usable and robust) benchmark.
However, it is also true that banks no longer rely on interbank funding as much as they used to, and that 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 tenors such as the overnight maturity still generate enough turnover for the construction of robust benchmarks. An in-depth analysis is therefore needed to identify which benchmarks are viable, how these benchmarks can be built to withstand changes in market structure over time, and also how market usage of benchmarks can be oriented towards such benchmarks.
In the meantime, the money market statistical reporting (MMSR), which will form the basis for the ECB’s overnight rate, offers the option of taking into account transactions between the reporting agents (banks) beyond the interbank market, i.e. transactions with other financial counterparties, such as monetary financial institutions (MFIs), official sector institutions, insurance corporations, pension funds, general government and central banks, as well as non-financial corporations classified as “wholesale” according to the Basel III liquidity coverage ratio framework. The scope of the transactions taken into account will be defined during the design phase of the ECB’s overnight rate.
Developing a benchmark is a complex process and entails much more than elaborating a 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, a transparent and broad communication with the public, involving public consultations, will be necessary to gain insights into user needs.
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. 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 will be 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.
They will have one feature in common – they will both rely on transactions from the overnight unsecured segment.
On the other hand, they will differ in several ways. First, EONIA is administrated by the private sector via the European Money Markets Institute (EMMI), while the ECB’s new overnight rate will be administrated by the Eurosystem. EONIA relies on voluntary data input by 28 panel banks (with one contribution per bank), while the ECB’s new rate will be built on the daily data submissions of the banks reporting under the MMSR regulation. Moreover, the methodology of EONIA is a weighted average rate of the submitted contributions; the methodology of the ECB’s new rate will be defined later, but should rely on individual transactions rather than on a single contribution per bank.
The ECB’s initiative is intended to complement the existing benchmarks and serve as a backstop to market initiatives. EONIA has its own underlying interest and specificities, and therefore, the future usage of such a widespread benchmark is difficult to predict. As long as market participants are content to use EONIA as a reference rate for their contracts, they should do so.
The ECB’s new rate will be launched on the basis of the 52 reporting banks fulfilling the criteria specified in the current MMSR regulation. A decision will be taken on any possible additional reporting banks before the end of 2018.
The methodology of the benchmark together with other design parameters is currently being discussed within the Eurosystem. The ECB intends to launch public consultations early next year on the content of the methodology in order to ensure transparency and, most importantly, to collect feedback to ensure the usability of the new rate.
The ECB will remain the calculation agent for EONIA while the benchmark is critical for the financial markets and the ECB’s involvement is essential for the continuity of the index.