Jacob Rank-Broadley
- EURIBOR remains in use, creating a multiple-rate environment with the new €STR benchmark.
- Robust fallback provisions are essential to future-proof interest rate contracts.
- Forward-looking RFRs provide clarity and reduce confusion in benchmark comparisons.
Are regulators now satisfied?
At first glance, interest rate benchmark reform in the eurozone is now done and dusted.
Following the 2012 LIBOR scandal, public/private working groups started working on identifying the most suitable risk-free rates within each currency area. These groups were usually hosted and chaired by local central banks and securities market regulators.
But in the eurozone, it was decided in 2019 to leave the main legacy benchmark--EURIBOR®--in operation. This approach contrasts with that taken in other interest rate markets, such as sterling and the Swiss franc, where the switch to RFRs was effectively made mandatory.
“A multiple-rate environment operates in the eurozone,” the euro working group stated in December.
EURIBOR® is based on the average interest rates at which a large panel of European banks borrow funds from one another. Its methodology was reformed in 2019 and it still serves as the reference rate for many euro-based financial products like swaps, futures, saving accounts and mortgages.
€STR is the RFR intended to serve as an IBOR alternative. It reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area and is calculated by the European Central Bank (ECB).
In December 2023, ESMA, in its capacity as secretariat of the working group on euro risk-free rates, issued its final statement and announced the discontinuation of the group.
Five factors determining future developments
The working group may now be a thing of the past.
But five factors still play a role in the ongoing adoption of RFRs as fallbacks and their role as primary benchmark references in financial contracts.
1. The need for fallbacks
Based on FTSE Russell’s conversations with clients, many market participants are still unaware of the requirement to include robust fallback language in interest rate contracts referencing legacy IBOR benchmarks.
The absence of fallback provisions can cause major problems if a benchmark disappears or falls out of favour, as LIBOR did in the last decade. The euro risk-free rate working group is unequivocal on the need to future-proof loan and derivatives contracts.
“Robust fallback language enhances legal certainty for market participants by increasing contract robustness and ensures compliance with the EU Benchmark Regulation,” the working group said in its final statement.
“While EURIBOR® is not scheduled to be discontinued, this should not be a justification to avoid or delay implementing suitable fallback provisions”, it went on.
2. The need for forward-looking RFRs
The switch from legacy IBOR benchmarks to RFR benchmarks has caused some confusion, inherent in their differences in design.
LIBOR and its equivalents were based on banks’ unsecured borrowing rates one week, one month, three, six and twelve months into the future. These rates therefore incorporated both term and credit risk premia.
By contrast, RFRs are overnight and several of them are based on secured (collateralised) borrowing. They have no term premium and effectively no credit premium. To make an apples-to-apples comparison between IBOR benchmarks and RFRs isn’t straightforward.
Forward-looking (or “term”) RFRs eliminate some of the potential confusion because they reflect the market-implied expected path of overnight rates over a set term. These implied rates can be sourced from the interest rate derivatives market.
In 2021, the working group on euro risk-free rates recommended that market participants use forward-looking RFRs as a fallback benchmark in some IBOR contracts. It added that they could use historic (backward-looking) RFRs if the forward-looking fallback wasn’t available as a second level in a waterfall.
In 2023 the working group reiterated the importance of the adoption of EURIBOR fallback rates and trigger events in new and refinanced euro-denominated corporate lending products. It said these contractual provisions are needed to avoid operational and market disruption risks.
Competing forward-looking term RFRs are now available: they are offered by the European Money Markets Institute (“EMMI”, the administrator of the EURIBOR® and EONIA® benchmarks) and by FTSE Russell and are called EFTERM® (EMMI) and Term €STR (FTSE Russell).
3. Healthy markets
Just as fallback interest rate benchmarks provide for the possible future discontinuation or illiquidity of legacy benchmarks, market participants may wish to diversify amongst benchmark providers as well. Those benchmark administrators with demonstrated market knowledge and robust products, based in real trading activity, are the best-equipped to survive over coming years and decades. Having a choice of data vendors provides for efficient and healthy markets.
4. Trade-based
In 2014, at the outset of the interest rate benchmark reform process, the Financial Stability Board said that the new risk-free rates should be anchored in observable transactions, wherever feasible, and should be robust even in the face of market dislocation. The regulatory body also said that RFRs should minimise the opportunities for manipulation.
FTSE Russell’s Term €STR benchmark meets the regulatory gold standard in two ways: it is calculated using executed swap trade data and committed (i.e. executable) quotes for €STR Overnight Index Swap (“OIS”) contracts, one of the most liquid financial markets in the world; and its data sources are two of the largest global market infrastructure providers—Tradeweb and LCH SwapClear. These two platforms process trillions of dollars in interest rate contracts a year.
5. Different adoption rates
Not all market participants are replacing IBOR benchmarks at the same pace.
According to Risk magazine, the participants at a Frankfurt-based Derivatives Forum, held in February 2024, expected switches from EURIBOR® to €STR to be gradual.
50 percent of attendees expected €STR to become the main interest rate benchmark for euro swaps within the five years, Risk said, with another 27 percent anticipating a hybrid market, with a greater tilt towards €STR than EURIBOR®.
But certain types of market participant may switch more slowly at first, then faster later, suggested Risk. Buy-side firms and real-money investors have been slower to loosen their grip on EURIBOR® but may end up as more wholesale adopters of RFR, it said.
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