Following several years of research, consultation and preparation, the European Central Bank (ECB) took €STR live on 2 October. €STR, or the Euro Short-Term Rate, is the new overnight interest rate benchmark for the euro and the first official daily fixing value of -0.549% was published at 08:00 Central European Time. Its introduction will have wide-ranging effects on financial markets, in particular on the interest rate swap market.
€STR goes live
The value of -0.549% reflects trading activity on the previous business day, 1 October. This differs from the previous overnight reference rate, the Euro Over-night Index Average (Eonia), which was, up to now, published on the same day at 19:00. Besides the new publication time, €STR will be based upon a larger number of transactions from a wider range of banks and reporting agents. The improved methodology means €STR should be a more stable and representative short-term rate than its predecessors.
Eonia remains in use
The administrators of Eonia, the European Money Markets Institute (EMMI), were previously given until 1 January 2020 to comply with the EU's Benchmarks Regulation. This deadline was subsequently extended by 2 years to 31 December 2021, at which point Eonia is due to be discontinued. Following consultations with stakeholders and the input of various working parties investigating benchmark reforms, it was decided earlier this year that, from 1 October 2019, Eonia will be calculated as a fixed spread of 0.085% or 8.5bps above the €STR fixing rate. For this reason Eonia will now be published at 09:15 CET on the following business day, shortly after the €STR rate is published. The Eonia rate for trading activity on 1 October 2019, published on 2 October, was therefore -0.464%.
As a proxy for long-term minimum-risk interest rates, Eonia term rates remain widely used for valuing interest rate swaps and other instruments. Eonia discounting curves are derived from Eonia interest rate swaps traded in the market. It will not be until long-term €STR swaps begin being traded with sufficient liquidity that €STR term rates will become available as a potential replacement. This means that, for the time being, Eonia term rates will remain the default choice for valuing interest rate swaps and calculating collateral requirements. Figure 1 presents the development of Eonia and Pre-€STR, the ECB's preliminary calculations of €STR before it went live.
Figure 1: Rate development of Pre-€STR and Eonia. Source: ECB, Aegon Asset Management, 16 September 2019.
Transitioning to €STR discounting
The two largest European central counterparties (CCPs), LCH and Eurex, have indicated that they will begin clearing €STR swaps in late October and November respectively, although it is likely to be some time until the markets are reliably liquid and deep. For cleared derivative trades, the ECB has recommended that CCPs align the dates at which they will switch from Eonia to €STR-based discounting, commonly referred to as a "big bang" approach. They have also suggested setting a date towards the end of Q2 2020. For bilateral derivative contracts, the ECB would prefer to see a phased approach to suit individual market participants although the timeline for these changes is likely to be influenced by the timeline chosen by the CCPs.
There are several options identified by the ECB for how a change to €STR-based discounting can be addressed for existing contracts, entered into on an Eonia discounting basis:
- The most likely option will be to adopt clean €STR discounting. This option has the advantage of bringing existing and new contracts under a single discounting regime. The downside is that the value of derivative contracts will change and, as a result, compensation will need to be applied (discussed further below).
- Another option, but unlikely to be widely used, will be to adjust the €STR discounting rates by the 8.5bps spread, effectively allowing Eonia discounting to be maintained beyond 2021. This has the advantage of avoiding changes in the value of contracts which would lead to the need for compensation but will also lead to considerably more operational complexity going forward.
The ECB has recommended clean discounting for cleared derivatives and, where possible, for non-cleared derivatives. The compensation could take the form of cash payments (from the beneficiary of the change to the other party to the swap) or the issuance of Eonia-€STR basis swaps. The ECB recognizes that cash settlement will be operationally much simpler but also that individual market participants may have circumstances which mean they prefer a basis swap solution.
We expect that clean €STR discounting will become the market norm. Indeed, LCH have identified this as their preferred method, together with cash compensation. Investors may therefore wish to review their swap portfolios in order to gauge the potential effect of moving to clean €STR discounting. In order to limit the size of the impact, re-striking swaps (closing contracts and re-opening at current market rates) may be one option, although this is likely to incur transaction costs. The period before €STR discounting is implemented may also be a suitable period for investors to consider the pros and cons of moving to central clearing, as this should lead to a more streamlined transition with lower operational risk than if several different counterparties to bilateral swaps are involved.
Euribor rates and their reform
Like Eonia, Euribor was deemed to not satisfy the Benchmarks Regulation requirements and it was decided that its methodology would be reformed. Following approval from the local regulator in early July, EMMI was due to begin the transition to the new methodology in Q3 2019 with completion expected by the end of the year. There is not expected to be any biased material change in the level of Euribor as a result of this reform and so no specific action is required from investors holding Euribor referenced instruments – Euribor remains Euribor, at least for the time being.
Euribor rates will not be directly affected by the transition to €STR. There may be indirect market effects on the level of Euribor rates, although these will be very difficult to determine and isolate from general market movements. It is also likely that €STR will become a fallback rate for Euribor, referenced in contracts in case Euribor rates ever become unavailable.
In the longer term, it is many observers' view that €STR may eventually replace Euribor as the standard reference rate for euro interest rate swaps. This will create a much simpler interest rate swap world in which floating leg cashflows and discounting are calculated using the same underlying interest rate, much as the situation was before the great financial crisis when Euribor rates often served both purposes.
However, if this transition does occur, it will also have profound implications for regulators and institutional investors, such as Dutch pension funds, who value their liabilities using Euribor term rates. Without an adjustment mechanism, the liabilities would increase: the spread between 6 month Euribor and Eonia at the 20 year maturity point is currently over 15bps, meaning a 20 year liability valued using €STR rather than 6 month Euribor might be around 5% higher. If €STR does eventually become the default reference rate, the question will then arise as to whether regulators will require institutional investors to adopt €STR discounting and if there will be any form of mitigation for the resulting increase in liabilities.
All figures quoted are provided by the ECB.