Jacob Rank-Broadley
Whilst the Eurozone market has lagged behind USD, GBP and JPY in the transition to risk free rates, things might be about to change due to improved €STR liquidity and the introduction of term rate benchmarks.
- LIBOR passed into history at the end of June, but its Eurozone equivalent limps on.
- Despite concerns over EURIBOR®, and the risks of continuing to use it, users have been relatively slow to switch to €STR, in part because it involves switching from a forward-looking rate to a backward-looking methodology.
- With improved liquidity and the recent introduction of forward-looking term rate versions of €STR, market participants have fewer excuses not to adopt €STR
When will the market switch from EURIBOR® to €STR?
There is no better incentive to adopt a new benchmark than when the existing rate ceases. For this reason, it’s no surprise that we’ve seen slower progress in the Aussie dollar market where BBSW lives alongside AONIA than for LIBOR where the hard cessation dates played a key role in encouraging market participants to adopt the recommended replacement rate, SOFR. Today, for the euro market the overnight risk-free rate, €STR, lives alongside the well-established EURIBOR® benchmark and adoption of €STR is behind that of the currencies most affected by the LIBOR transition. According to the ISDA-Clarus RFR Adoption Indicator in July 2023 only 25% of euro DV01 referenced €STR, whereas for the same period 72% of USD DV01 referenced SOFR. Furthermore, in May 2023, the working group on risk free rates noted that €STR and Term €STR fallback rates have not yet generally been adopted in corporate lending products.
There are a range of factors that will likely determine for how much longer this dual rate environment can continue.
Percentage of DV01 per currency traded as an RFR
Source: ISDA-Clarus RFR Adoption Indicator
A loss in confidence in EURIBOR® could accelerate its demise. Minutes from the ECB Money Market Contact Group (MMCG) in December 2022, highlighted that concerns have been raised about the robustness of EURIBOR®. “MMCG members felt that the robustness of Euribor as a benchmark index has been suffering in general and acknowledged in particular that maturities up to three months adjusted sluggishly to rate changes…”. If market participants are unhappy with the performance of EURIBOR® they may consider €STR as an alternative reference rate.
A key factor when assessing the attractiveness of EURIBOR® alternatives is the level of liquidity. Here there are positive signs of €STR liquidity building. According to the ISDA Clarus RFR Adoption indicator 21-32% of euro DV01 traded referenced €STR on any month between January to July 2023 whereas for the same period the prior year this was 15-24%. Similarly, LCH SwapClear volumes show an improvement in the notional amount outstanding that is cleared by LCH. In July 2023 this reached US$43TN up 33% from August the prior year.
Notional amounts outstanding at month end (USD TN)
One of the key drawbacks associated with the migration from an IBOR to an RFR is switching from a forward-looking rate to one which is backward-looking. Some firms find the calculation and use of compounded in arrears rates more complex. For this reason, forward-looking term rates are popular in select markets. For example, in the US, there was some hesitancy to adopt SOFR prior to the ARRC support for CME Term SOFR in July 2021. The year after CME Term SOFR was officially endorsed SOFR adoption increased from 7.4% of DV01 to 49.7%. Whilst the endorsement of CME Term SOFR wasn’t the exclusive driver of SOFR adoption, it likely contributed to the switch. Forward-looking Term €STR benchmarks are now available.
Major banks were fined billions of dollars in connection with their contributions to IBOR benchmarks. €STR and Term €STR benchmarks aren’t based on panel bank contributions. It is unclear how much longer the 19 panel banks be willing to accept the operational risk associated with contributing to IBOR benchmarks such as EURIBOR® when there are now alternative rates. If the number of contributors were to drop significantly, this could raise questions over the robustness of the benchmark.
What will the transition look like?
In the United States we’ve seen LIBOR replaced by a family of different benchmarks, most of which are based on SOFR. For legacy transactions there are different fallback conventions for derivatives and cash products. The fallbacks for legacy derivatives are based on SOFR compounded in arrears plus a static spread adjustment and for cash products, such as loans, bonds and securitised instruments we’ve seen a range of different conventions, but a spread adjusted Term SOFR (produced by Refinitiv) is probably the most popular option. For new instruments there’s no need to apply a spread adjustment so compounded SOFR in arrears is widely used in bonds and derivatives, and Term SOFR is used in loans. Interestingly, the US market has put fewer restrictions on the use of Term SOFR than the UK market has introduced for Term SONIA. This has resulted in much more extensive use of term rates in the USD market.
The Euro working group on risk-free rates, has issued recommendations on conventions for the introduction of fallbacks for legacy instruments that are broadly aligned with the US advice from the ARRC. However, working group support for use of €STR, particularly Term €STR, in new instruments remains a little less clear.
How do I select an appropriate term rate benchmark?
With many firms wanting to retain a forward-looking benchmark, Term €STR is an important benchmark for the euro market. However, unlike the US there is no single endorsed rate so market participants will need to choose the rate that best meets their needs. The following factors could influence your decision:
From a regulatory perspective, BMR states “Input data shall be transaction data, if available and appropriate” so the use of trade data as an input into the Term €STR supports the benchmark accurately and reliably represents the economic reality. Refinitiv Term €STR is the only euro term rate benchmark directly based on more than five trillion euros of executed trades.
A long collection window provides time to collect more data. This reduces the risk that the benchmark is based on a small number of trades or counterparties and thereby making the benchmark more robust. Refinitiv Term €STR uses a collection window of 09:00-18:00CET from the previous business day. This maximises the volume of data collected.
There are now several exchanges that offer €STR futures. Whilst liquidity is building, activity remains limited when compared to the equivalent EURIBOR contracts. For this reason, it remains unclear whether futures data is yet a sufficiently robust input into a Term €STR benchmark. Refinitiv Term €STR is based primarily on €STR OIS contracts and doesn’t use futures data as an input.
Disclaimer
EURIBOR® is the registered trademark of and used under licence of EMMI a.i.s.b.l. The source of EURIBOR® data is the EMMI.
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