Following the Libor scandal which came to prominence in 2012, interest rate benchmarks have been under significant scrutiny across global financial markets. This has led to various proposals for reforms or replacements of interest rate benchmarks. These serve as a reference rate for standardized interest rate derivative contracts as well as for other financial instruments. One change of particular interest for European investors is the switch from Eonia, the euro’s current overnight reference rate, to the proposed ESTER (euro short-term rate).
Written by Menno Altena, Investment Strategist at TKP Investments, and Oliver Warren, Investment Solutions Consultant at Aegon Asset Management
Across many currencies, changes to interest rate benchmarks are underway or have already been initiated. Earlier this year, the New York Federal Reserve started publishing the Secured Overnight Financing Rate which is likely to replace US Dollar Libor. The ECB has also started publishing pre-ESTER, a forerunner to ESTER which is due to begin being published next year. This is ahead of 2020 when Eonia will cease to be an official reference rate. ESTER will have several benefits from a financial stability perspective including being more representative of rates in the market, less susceptible to manipulation, as well as more stable. However, the difference between the two rates is not expected to be negligible, as demonstrated by the chart below.
Figure 1: Rate development of Pre-ESTER and Eonia. Source: ECB , 15 March 2017 to 30 October 2018.
In this article, we discuss the implications of these changes as well as looking at how investors might seek to prepare for the introduction of ESTER. This may include reviewing their swap (and other interest rate derivative) positions, looking at the pros and cons of bilateral versus centrally cleared swaps, as well as investigating whether it is worthwhile re-striking their positions to minimize the effect of the change in discount rate.