While working groups in other currencies had selected alternative risk-free rates (RFRs) to Libor for swaps contracts and were planning the transition process, hardly any headway appeared to have been made in the Eurozone—the second-largest interest rate swap market in the world. “They’ve wasted a lot of time and achieved precious little,” said a portfolio manager at a pension fund management firm in London. Worse, the number of banks submitting to the Euribor panel had fallen to a level where market participants were concerned about the prevailing benchmark’s near-term future. And the most viable replacement, the Euro OverNight Index Average (Eonia), was similarly weak.

Just as market participants called on the ECB to step in to prevent the market from “sleepwalking into a situation where nobody is submitting to the Euribor panel but there’s no credible rate to replace it,” the ECB did just that. The regulators will convene a new industry working group to identify an alternative RFR to Euribor for the swaps market, in line with a global push started by the Financial Stability Board (FSB) that began in 2013 to wean the market off solely relying on the Libor benchmark. Also, using the money market data it collects to monitor the transmission of monetary policy, the ECB will create a new unsecured overnight benchmark as a backup, or potential rival, to Eonia. 

It is not a foregone conclusion that the ECB’s new overnight benchmark will be selected as the official RFR for the €180 trillion ($210 trillion) euro interest rate swaps market, however. It will be up against at least two other candidates: a strengthened Eonia, or a new secured rate based on European government repo trades currently being developed by Emmi. Most market participants felt—even in the absence of hard information on its design—that an ECB-created benchmark should be more robust in terms of underlying volumes than Eonia.

But the dilemma for Europe’s regulatory authorities now, they point out, will be to decide whether a new RFR can eventually replace Eonia without causing severe disruption to legacy portfolios. It wouldn’t just affect the Euribor–Eonia basis market, which has an estimated notional amount of €5.2 trillion ($6 trillion). Eonia is also widely used as the discount rate to determine the present value of future cashflows for Euribor-linked swaps collateralized with euro cash. Unless the new rate matches Eonia exactly, a move will lead to a value transfer between counterparties that could trigger legal disputes. 

Some say it could take years to properly build out a swap curve based on a new benchmark rate. “If the ECB makes a new index everyone agrees is better or more accurate than Eonia, then the problem will be the building of a new swap market,” says Eske Traberg Smidt, head of global rates trading at Danske Bank in Copenhagen. “That cannot be done overnight, and it is not something I think the market is prepared to do at the moment.” 

Eonia’s Drawbacks 

Until the ECB’s announcement in September, it had been widely expected that swaps users would choose to use Eonia, the prevailing unsecured overnight benchmark rate for euro transactions, as an alternative RFR in the euro area. Structural changes in the market have brought the rate’s credibility into question over recent years, however. Unsecured lending between banks has been declining in Europe since the crisis: partly due to regulatory changes, and partly due to the ECB’s ultra-loose monetary policies. Transaction volumes used to calculate Eonia have consequently fallen. 

“We all know the drawbacks of Eonia,” says Adam Kurpiel, a derivatives rates strategist at Societe Generale Corporate and Investment Banking in London. “Because of the regulatory framework and the very high excess of liquidity in euro money markets, volumes in Eonia have fallen to around €10 billion ($12 billion) a day for the last year or so. And that doesn’t look like it’s going to change anytime soon.” 

Danske Bank’s Smidt adds that declining volumes in the unsecured overnight deposit market tracked by Eonia is making the rate a much less reliable indicator of rates in the cash market. “We are seeing an increased discrepancy between where the fixing is and what I as a dealer am paid in overnight cash,” he says. “We have an Eonia fixing that is roughly –36 basis points, but I would say –47bp is a more accurate reflection of where cash is trading. Volumes are so small now it’s almost beyond belief. If one of those panel banks decides tomorrow that instead of rolling 10 yards in repo they are going to use overnight deposits, then the market would double in size and the Eonia fixing would move about six basis points lower.”

The panel that sets the Eonia rate is only a subset of this shrinking market, and the panel itself has shrunk dramatically in recent years. After German lender Commerzbank became the latest to withdraw from providing contributions in July, only 28 banks remain on the panel—down from 44 in 2013. These range from international dealers such as Barclays and Deutsche Bank to smaller players like the National Bank of Greece and Luxembourg’s Banque et Caisse d’Épargne de l’État. However, roughly 80 percent of daily transactions come from just five panel banks, according to research by the ECB’s money-market contact group. 

Much then rests on the outcome of a data review currently under way, in which the rate’s administrator, Emmi, will perform an analysis of panel bank transactions from September 2016 to February 2017. The purpose of the exercise, part of a two-stage review launched by Emmi in 2015, is to identify ways to make the benchmark more representative of the market it references. According to Emmi, this could include efforts to broaden the Eonia panel, as well as revising the methodology to include a broader set of transactions and eligible counterparties. 

Yet there is concern on the Euribor–Eonia Steering Committee—an industry group assisting Emmi in the review—about whether such reforms might make it too different to the current rate. A 2014 report published by the FSB-established Market Participants Group on Reforming Interest Rate Benchmarks, found a difference of just five basis points could affect the willingness of market participants to transition to a new reference rate. 

“The problem is continuity,” a source close to the steering committee says. “We fear that if the methodology changes too much, then there could be a legal question about whether it is a new index or a continuation. The new rate would be more or less the same as Eonia, but there might be a change in the level of a few basis points.” 

On the other hand, a reformed Eonia could be the best option in terms of continuity, one swaps user points out. After all, unlike its two rivals, it would not be a completely new rate requiring a new market infrastructure to be built from scratch. “Choosing a reformed Eonia would have the advantage that a basis market already exists for Euribor-Eonia,” says a London-based portfolio manager. “If not, then we could all be faced with a situation like in the US, where dealers will have to first be pushed to bilaterally trade products in a market where they are not comfortable doing so.”

Danske Bank’s Smidt agrees, pointing out it may take a long time for swaps users to become comfortable with an entirely new benchmark. On that basis, he believes a bolstered Eonia being selected as the new RFR would be the best possible outcome for market participants. Ideally, he would like to see the ECB’s efforts to develop a new RFR merge with Emmi’s efforts to reform Eonia. 

“I think the only viable way forward is the Emmi-led Eonia reform process,” he says. “With a new index, any reasonable trader would have to ask themselves how much confidence they can have in the new index. For example, a few years ago, when we had capital controls introduced in Cyprus, there was a significant risk Euribor could spike. How would a new index behave in a scenario like that? It’s difficult to know when the rate has no track record.” 

An Emmi spokesperson says, “At this stage we have no views on the use of Eonia in the future. Its market acceptance will have to be decided by the industry in due course.” 

The Secured Option 

The same challenges would apply if moving to a rate based on euro repo transactions. Yet swaps users are heartened by the fact the secured option would at least not suffer from the same dearth of underlying transaction volumes as Eonia has in recent years. Since the 2008 financial crisis, while unsecured overnight lending has been a declining source of funding for banks, liquidity in the secured segment of the market remains robust, with aggregated daily volumes of roughly €250 billion ($292 billion).

“From a purist point of view that might be viewed as the best outcome,” says the London-based portfolio manager. “That’s where all the liquidity is now in the short-term funding markets.” 

Selecting a secured rate would also align Europe with other currency working groups such as the Swiss franc and US dollar, both of which have opted for repo-based benchmarks. Market participants have warned fragmentation of the underlying RFRs could hit the cross-currency basis, for instance. Although Emmi refrains from explicitly backing a rate to become the new RFR, maintaining that the market itself should decide, it believes the new repo rate could serve that purpose. 

“I think it could be a viable RFR,” says Petra de Deyne, manager of Emmi’s benchmark governance unit. “It’s up to the market to decide which rate it uses and for which purpose, so my view is that it would be healthy to have various types of benchmarks co-existing for the euro market, be they secured or unsecured rates.” 

In August, Emmi published the results of a three-month industry consultation on the proposed definition of the new repo index and its calculation methodology. In a preliminary statement in December, Emmi said the new rate would focus on anonymous euro-denominated alternative trading system transactions, which are cleared through eligible clearinghouses. Data published in the consultation shows the underlying volumes available for Emmi’s proposed repo index far outstrips those of Eonia. Emmi noted the feedback was generally positive, but admitted there was some concern about using the rate to discount cash-collateralized euro interest rate swaps. 

Swap users believe discounting rates should be based on the interest rate of the underlying variation margin. For cash-collateralized euro interest rate swap trades this should be Eonia, while for bond-collateralized swaps, it should theoretically be the repo rate. 

Others pointed to the probable basis between the new repo rate and Eonia, which would change an instrument’s present value in a transition. According to data presented in Emmi’s consultation paper, the proposed repo rate would have tracked roughly five basis points higher than Eonia throughout much of 2015. 

“Repo should not directly replace Eonia,” says the source close to the Euribor–Eonia Steering Committee. “Especially while we are still in quantitative easing, there’s too large a quantitative difference. But it could be an alternative.” 

Europe’s Sonia 

For the time being, the ECB’s proposed unsecured overnight rate is still an unknown quantity. The central bank said it will construct the rate using its money market statistical reporting (MMSR) data, and aims to finalize it by 2020. The bank has been collecting transaction data from European lenders since April 2016 as part of efforts to monitor the transmission of its monetary policy decisions to the markets. Market participants expect a rate similar in design and methodology to the Bank of England’s reformed overnight rate, Sonia. 

“The best data we have in the euro market is the MMSR,” says Societe Generale’s Kurpiel. “Based on this data, they could potentially create something similar [to reformed Sonia], because the technical infrastructure is the same. In my opinion that’s the best choice.” 

Danske’s Smidt says the new ECB rate might be closer to Euronia, the volume-weighted index of unsecured euro overnight cash transactions brokered in London by contributing Wholesale Markets Brokers’ Association member firms. If that proves to be the case, he says, the rate would be much more representative of the cash market than Eonia in its current incarnation. “If you ask any bank what they charge traders when they have excess liquidity on their trading books at the end of the day, they would probably give you a rate closer to Euronia,” he says. 

There is also a feeling in the industry that the ECB would not embark on such a time-consuming and complex exercise to develop a rate nobody ultimately uses. 

“If they are going to do all this work and get it ready by 2020, they are going to want to be pretty sure the market will be using it,” says the pension fund manager. “They are not going to want to have a situation where the ECB has done all of this work and the new unsecured rate doesn’t really go anywhere because another rate has been launched based on secured transactions. For them to be investing all this time and effort, I’m sure they will want it to be designated the RFR and for it to have that credibility behind it.”