8/ Interest rate benchmark reform

5 August 2021 

Blog post by Gaston Reinesch, Governor of the BCL

  

INTEREST RATE BENCHMARK REFORM[1]

  

INTRODUCTION

This article analyses the importance of money market reference rates from a double perspective. On the one hand, its objective is to make the public aware of the different reference rates in the money market and their great impact on capital markets and the real economy. On the other hand, this article sheds light on global reference rate reforms undertaken over the last few years. Thereby, it raises awareness of the reform outcomes and the need for adaption by market practitioners in the very near future.

  

SUMMARY/ABSTRACT

Money market reference rates play a key role in the transmission of monetary policy. By setting key policy rates and managing liquidity in the money market, central banks steer short-term nominal money market rates and exercise substantial influence over a wide range of interest rates, spending decisions of businesses and households and, ultimately, the price level. Money market reference rates are widely used by agents as a basis for the remuneration rate/cost of borrowing in various types of financial contracts such as mortgages and bank overdrafts. Reflecting their role in the transmission process and their wide use in financial contracts, money market reference rates must be reliable, available at high frequency and representative of the interest rate agreed between money market participants. Since the global financial crisis, however, the role of some money market reference rates suffered from conceptual weaknesses[2] and/or changes in the functioning of money markets. Against this background, great efforts have been made to reform some reference interest rates; a very important milestone of this reform will be reached at the turn of the year 2021/2022, for which market participants need to prepare.

  

1. REFERENCE RATES AND THE SECURED AND UNSECURED MONEY MARKETS

The money market, a key segment of financial markets, brings together a wide range of actors (such as central banks and commercial banks, but also non-bank businesses and public institutions) exchanging liquidity via transactions with a term of up to one year.

The money market transactions can be executed either in secured form or in unsecured form. In the secured market segment, the lender receives securities in return for the liquidity lent in a so-called repo or securities lending transaction. Due to the collateral deposited, credit risk is largely eliminated and therefore the interest rates on these transactions are lower; in general it holds that the higher the credit rating of the collateral, the lower the interest rate. The unsecured money market, on the other hand, is based solely on the mutual trust of the business participants. The interest rate is primarily determined by the creditworthiness of the debtor.

  

2. EVOLUTION, FUNCTIONALITY AND DESIGN OF GENERALLY ACCEPTED REFERENCE RATES

In the 1980s, in the course of the expansion and integration of global financial and money markets, the need for a generally accepted reference interest rate in the unsecured money market segment increased. This development was also driven by the desire to use a uniform interest rate benchmark in the multitude of contracts for financial products. On this occasion, a banking consortium was formed in London, which established a reference rate called LIBOR (London Interbank Offered Rate); the first fixing took place on 10 January 1986. From the beginning, the calculation was kept relatively simple: A group of banks, called the panel, transmitted the key figures of their financial transaction on the unsecured interbank market, first and foremost the interest rate, the volume and the maturity, to an administrator.[3] After a trimming process[4], the fixing for the same day was published; it was regarded as the authoritative interest rate reference for all market rates. In a short time, LIBOR was extended to other currencies[5] and quickly gained global significance. The economic importance of LIBOR also quickly gained momentum as it spilled over into the credit and derivatives markets. To this day, many mortgage and corporate loans, floating-rate bonds or interest rate derivatives are based on LIBOR. To date, LIBOR is published in seven different maturities: daily, 1-week and 1-/ 2-/3-/ 6-/ and 12-months.

In Europe, there have been similar efforts[6] at that time which ultimately led to the common reference rate EURIBOR (Euro Interbank Offered Rate) from 1999 onwards. This reference interest rate was also determined on a daily basis with the help of panel banks; however, expert estimates are used in this approach. At the current juncture, EURIBOR is defined as the rate at which banks in the EU and European Free Trade Association (EFTA) can obtain funds in the wholesale unsecured market. The EURIBOR reference rates are published for different term structures; interest rates are available for 1-week and 1-/ 3-/ 6-/ and 12-months.

The EONIA (Euro OverNight Index Average) is an overnight benchmark rate for the euro.[7] The EONIA was launched by the European Banking Federation (EBF) in cooperation with the ECB in 1999. As with EURIBOR, the EMMI (European Money Markets Institute) acts as administrator. [8] The interest rate is considered a widely recognised benchmark in the unsecured money market and has become globally significant. EONIA’s calculation - in its original conception - was based on the weighted average of unsecured overnight lending transactions in the EU and EFTA interbank market.

  

3. THE REGULATORY NEED FOR ACTION AND RECENT REFORMS

Since the global financial crisis, the role of some money market reference rates suffered from conceptual weaknesses and/or changes in the functioning of money markets. Investigations after the LIBOR scandal of the decade prior to 2012, for instance, suggested that, first, banks had incentives to deliberately pass on too low interest rates to the LIBOR Committee in order to strengthen their own position. Second, it was revealed that some banks manipulated the interest rate upwards or downwards in a concerted effort to improve profit prospects in derivatives trading; even small changes in a reference interest rate can yield considerable profits in a large derivatives portfolio. Third, there was a renewed awareness that it is a clear methodological weakness if panel banks did not report actual interest rates, but only estimates.

EONIA, by contrast, suffered from a substantial decline in underlying transactions and high concentration of trading volumes by only a few contributors.

As a result, various reform efforts were launched at international and national level with the aim to strengthen the representativeness and reliability of the existing reference rates and/or developing robust alternatives. Due to the global reach of the reference rates in question, the reform process is coordinated globally under the lead of the Financial Stability Board (FSB) on behalf of the G20. The stakeholders in this process also include central banks and supervisory authorities. These institutions are complemented and supported by an international group of financial market participants from the private sector. Another important part of the reform work was to examine the extent to which LIBOR interest rates meet the requirements set by world’s securities regulators (IOSCO standards)[9], whose focus lies on improving the transparency, methodology (moving from quotes to transaction-based wherever possible) and supervision of reference rates, with the ultimate aim of strengthening trust and credibility. In 2014, the FSB paved the way for reform with two key recommendations: On the one hand, it emphasised the importance of fall-backs, i.e. temporary solutions if a contractually fixed reference interest rate should default. On the other hand, it steered the focus towards risk-free rates (RFRs) to ensure a uniform standard across markets; RFRs are interest rates that are literally not affected by credit risks. The work was subsequently handed over to individual public and private sector working groups, e.g. the “Working Group on Euro Risk-free Rates” in the euro area.[10] BCL is in close contact with this working group to discuss the latest development in the reform process.  

  

4. OUTCOME OF THE REFORM AT INTERNATIONAL AND EUROSYSTEM LEVEL

At the start of 2018, the EU-BMR (Benchmarks Regulation), based on the IOSCO scheme, came into force.[11] Reference rates that do not meet the requirements of the EU-BMR may no longer be used as of 2022.

Currency	USD	EUR	GBP	CHF	JPY
	SOFR	€STR	SONIA	SARON	TONA
	Secured Overnight Financing Rate	Euro Short-Term Rate	Sterling Overnight Index Average	Swiss Average Rate Overnight	Tokyo Overnight Average Rate
Administrator	Federal Reserve Bank of New York	European Central Bank	Bank of England	SIX Swiss Exchange	Bank of Japan
Market segment	Secured money market	Unsecured money market	Unsecured money market	Secured inter-bank money market	Unsecured money market
Maturity	Overnight	Overnight	Overnight	Overnight	Overnight
Publication	Since 04/2018	Since 10/ 2019	Since 03/1997	Since 08/2019	Since 11/1997

For the euro area, it was clear that EONIA and EURIBOR are no longer compliant with the EU-BMR. Therefore a new reference rate called €STR has been published by ECB since 2 October 2019, for each TARGET2 business day, based on transactions conducted and settled on the previous day (reporting date T) with a maturity date of T+1.^[12]

The €STR is a rate exclusively based on borrowing transactions[13] in Euro conducted with financial counterparties that banks report to the ECB in accordance with the MMSR (Money Market Statistical Reporting) Regulation; it is calculated using overnight unsecured fixed rate deposit transactions over € 1 million. The range of reporting entities to the €STR is much broader compared to the EONIA since a variety of non-bank counterparties are taken into account, such as investment, pension and money market funds – and even central banks. This expansion compensates to some extent for the declining number of transactions on the interbank market. It therefore makes the determination of the rate more meaningful and less open to manipulation. The EONIA can still be used until the end of 2021; but under a reformed framework according to which its calculation is based on the new €STR plus a spread of 8.5 basis points.[14]

Unlike the EONIA, the EURIBOR is not discontinued. However, the EURIBOR is now calculated differently, taking into account the requirements of the EU-BMR. As a result, the expert estimates used in the past are subordinated and transaction-based data are primarily taken for calculations. Furthermore, the range of counterparties in the unsecured money market has been expanded. In July 2019, the supervisory authority had accepted the new calculation method for EURIBOR. This means that contracts with longer maturities can still be referenced to EURIBOR. However, it is necessary that fall-back provisions, for the case EURIBOR were to be terminated one day in the future, are implemented into contracts referencing EURIBOR.[15] Against this background, contracts with EURIBOR specifications must be robustly designed to minimise legal disputes and operational risks in the future.

As part of its mandate, with the aim of ensuring a smooth transition in case EURIBOR permanently ceased to exist, the Working Group on Euro Risk-free Rates published recommendations for fall-back provisions in May 2021. [16]

In essence, fall-back provisions consist of three key elements: trigger events, fall-back rate and spread adjustment. These three elements have been extensively described on a use-case basis; the information will be made available to market participants as practical guide.[17]

  

OUTLOOK

EURIBOR and LIBOR are critical benchmarks on which many products in the financial industry are based. This makes their discontinuation at short notice impossible and an orderly transition is needed. In November 2020, the IBA announced its plan to cease publication of LIBOR rates for GBP, EUR, CHF and JPY after 31 December 2021; the same deadline also holds for 1W and 2M tenors of USD LIBOR. However, publication of all other tenors of USD LIBOR, notably 3M and 6M, will be stopped after 30 June 2023. These deadlines are irrevocable and despite the Covid-19 crisis, have not been softened. On 5 March 2021, the UK regulator FCA (Financial Conduct Authority) explicitly reaffirmed: “[…] that all LIBOR settings will either cease to be provided by any administrator or no longer be representative: immediately after 31 December 2021, in the case of all sterling, euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings; and immediately after 30 June 2023, in the case of the remaining US dollar settings”.[18] Therefore, in the run-up to the effective entry into force of the implementations as of 3 January 2022, it is important to raise once again the awareness among all market players about the upcoming changes.

Although many market actors and institutions are well prepared for the transition - also because they were directly involved in the reform process - it is still unclear whether the significance of this transition is already anchored in the market on all sides.

First and foremost, it is up to the private sector to ensure their readiness for the termination of EONIA and LIBOR and the legal requirement of implementing suitable fall-back language in their contracts.

BCL is monitoring closely recommendations from all international RFR working groups and notably developments in the Luxembourg market place. The BCL expects from market participants that they do not delay the necessary action in relation to the interest rate benchmark reforms.

Undeniably, this transition can be seen as a once in a generation effort. After a long reform journey, the finish line is now only a few months away. This should be reason enough for all market players to verify their legal and technical readiness one last time.

  

 

[1] I would like to thank the staff from BCL-OP1 and M. Lempe in particular for their support in preparing this article.

[2] The certainly most prominent example of the abuse of methodological weaknesses came to light in the revelation of the fraudulent manipulation of the central reference rate LIBOR and other interbank rates in 2012.

[3] Since its foundation the BBA (British Bankers’ Association), from February 2014 the IBA (ICE Benchmark Administration).

[4] In the trimming process, the lowest and highest values are cut off from the data set. In this way, outliers are removed and the data set is further shortened. In the case of the GBP-LIBOR and the 16 panel banks involved, the four highest and the four lowest interest rates are cut off.

[5] In its founding year, LIBOR was designed for three different currencies (GBP, USD, JPY). Over the years, it expanded its significance to 10 and later even to 16 currencies. Currently, only the five currencies GBP, USD, EUR, JPY and CHF remain, where EUR LIBOR lost significance against EURIBOR.

[6] Such as with the FIBOR (Frankfurt Interbank Offered Rate), the PIBOR (Paris Interbank Offer Rate) or the HELIBOR (Helsinki Interbank Offered Rate).

[7] Unlike the EURIBOR, the EONIA is calculated by the ECB and is based on actual interbank transactions.

[8] The European Money Markets Institute (EMMI) was founded in 1999, coinciding with the introduction of the Euro. Formally, it is a non-profit association; constituted by the national banking associations in the EU. The EMMI has its headquarters in Brussels.

[9] In July 2013, the IOSCO (International Organization of Securities Commissions) published new principles for reference rates in financial markets.

[10] Further working groups are “Alternative Reference Rates Committee (ARRC)” for the US, “Working Group on Sterling Risk- Free Reference Rates” for UK, “National Working Group on Swiss Franc Reference Rates (NWG)” for Switzerland and “Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks” for Japan.

[11] Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016: https://eur-lex.europa.eu/ legal-content/EN/TXT/?uri=CELEX%3A32016R1011.

[12] https://www.ecb.europa.eu/stats/financial_markets_and_interest_rates/euro_short-term_rate/html/index.en.html.

[13] Note that, prior to October 2019, EONIA was defined as a bank lending rate, which partly explains the 8.5bp spread between EONIA and €STR.

[14] The ECB calculated the 8.5 basis points spread based on daily EONIA and pre-€STR data in the one-year period from 17 April 2018 to 16 April 2019; the exact calculation method is published on the ECB's website (cf. https://www.ecb.europa.eu/press/pr/date/2019/html/ecb.pr190531~a3788de8f8.en.html).

[15] The EURIBOR could be discontinued if, for example, the administrator withdraws, numerous individual panel banks leave or the underlying liquidity is no longer considered representative.

[16] The requirements for fall-back provisions are laid out in EU-BMR, article 28.2.

[17] With regards to fall-back measures for cash products, for instance, the Working Group considered two types of €STR-based term structure methodologies (cf. https://www.ecb.europa.eu/paym/interest_rate_ benchmarks/WG_euro_risk-free_rates/html/fallbacks_euribor.en.html).

[18] https://www.fca.org.uk/news/press-releases/announcements-end-libor.

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