With the publication of the officially endorsed Ester benchmark still a year away, the administrator of Europe’s two most widely used benchmarks, the European Money Markets Institute (EMMI), has been hard at work reforming Euribor so that it may be compliant with new European rules on reference rates. But EMMI’s outlook for Europe’s Ibor may be a little optimistic.
Benchmark rates that don’t comply with the European Benchmarks Regulation must no longer be used by January 2020. EMMI has already said Eonia won’t comply, but has been working on reforming Euribor so that it will.
On October 17, EMMI published a paper saying that the administrator is “confident” that its new hybrid methodology – which still relies primarily on transactions from panel banks but uses “other market-related pricing sources when necessary” – is compliant with BMR. EMMI plans to apply for authorization by the second quarter of next year.
EMMI reached this conclusion after testing the reformed methodology between May and August this year.
It may well be true that Euribor passes the BMR test, although even EMMI seems to express some doubt.
“Despite all the progress made by EMMI in enhancing the transparency and governance of the Euribor benchmark, the current methodology remains based on collecting quotes from contributing banks and the use of expert judgement,” the administrator says in the paper. Contributing banks and expert judgement are two things regulators particularly dislike about so-called Ibors.
But given Euribor is granted a stay of execution, the question remains of whether or not it is a sustainable benchmark. On this, the paper suggests good reasons for doubt.
First, only 16 of the 20 banks that now contribute transaction data (it used to be more than double that) for Euribor’s calculation agreed to participate in EMMI’s test of the new methodology. But only 15 banks’ submissions were used, as it “came to EMMI’s attention that [some of the banks’] contributions had ultimately not been done following EMMI’s guidelines.”
The erring submissions were ones that included "expert judgement" (though EMMI excluded all of the bank’s submissions as a result). That’s a good sign that the new methodology is complicated – too complicated for at least one contributing bank to understand and follow it.
Second, most of the activity the test captured in the euro unsecured money market was in the very short end of the market, meaning that, on the longer end, the reformed Euribor will have to rely mainly on expert judgements. EMMI produced a chart showing that underlying transactions beyond one week were based on less than 10 transactions with volume of less than €1 billion, and at some points in the curve there was no activity at all.
Transaction volume and sizes also appear to have declined since EMMI’s pre-live verification programme in 2017, implying that these levels could go even lower in the future, and more expert judgement needed. Levels were so low that EMMI announced it would be dropping the less significant tenors, leaving only one week and one-, three-, six- and 12-month tenors.
None of this bodes well for the benchmark, or those who are banking on being able to use it beyond 2020. Analysts at Commerzbank think it is very likely the BMR transition period will be extended to 2022, given Ester won’t even be published until October 2019 – three months away from the current deadline.
But others aren’t so sure. David Hiscock, a senior director at the International Capital Market Association, commented earlier to Euromoney that regulators and legislators aren’t enamoured of the idea of delaying BMR.
Which puts those who rely on Euribor (and Eonia) in quite a bind, indeed. Progress in creating a new benchmark to replace them is moving at a slower rate than progress in the US and UK, even though the BMR deadline is two years shorter, since banks will be compelled to submit Libor until the end of 2021.
It’s looking more and more likely that fall-back language will need to be used in the event that Ester can’t be adopted quickly enough and Euribor degrades in quality. But fall-backs that switch to Ester clearly won’t be available until it begins to be published regularly.
In the case of term floating rate instruments, Ester fall-backs would rely on a liquid swaps or futures market, which will take time to develop. It may be that backward-looking fall-backs need to be used on existing Euribor instruments, which is not ideal for market players that need cash-flow certainty. Any way you try to tackle it, there is going to be a lot of paperwork to do.
"Already existing FRNs [floating rate notes] raise more tricky questions, not least among which is that it is far from straightforward to change the language – so for the time being such deals will only fall back to whatever has been specified," says Hiscock. "For older deals, this risks seeing FRNs becoming fixed rate instruments, at the rate of their most recent fixing."
Or maybe there will be an extension to the BMR transition period. Fingers crossed.