The LIBOR related deadlines (end 2021) might seem far away but this doesn’t mean relevant things aren’t happening today. For example, next month the Euro short-term rate (ESTER) will supersede the Euro overnight index average (EONIA), which means EONIA as we know it will be no more. Last year, the European Central Bank (ECB) signalled they might be willing to extend the life of EONIA. Clearly this isn’t happening, so, what is? Well, an Ester + 8.5 bp will be published under the label of EONIA for the next two years. Surprisingly, this news didn’t stir up strong reactions from the market. So, let me explain why I was surprised and why I think some safeguards should be put in place in case you haven’t applied them already.
2 issues of the ESTER transition
- First, the minor issue of the missing rate on Tuesday October 1st. Most parties I know are simply aiming to avoid trading that day.
- Second, the characteristics of Ester + 8.5 are fundamentally different from those of EONIA. ESTER will reflect a broader part of the market due to the inclusion of wholesale lending. And this is the driver for the other main change; less human input.
Source:ECB
Characteristics of ESTER versus EONIA
The Gap
The 8.5 basis point difference is immediately clear. This gap seems rather stable, but there is only data available from times where the bazooka from Frankfurt pinned the rates to zero. Would this gap hold up when the rate environment would return to what we used to call normal?
Reduced volatility
You will probably also notice the volatility is reduced from EONIA to ESTER. Volatility equals risk and thus cost to the bank in terms of risk capital, which means costs to the bank’s customers. Feeding ESTER based data to unadjusted EONIA models will reduce the spread. But the fundaments of the market didn’t change, only the reference rates and this is undesired, right?
On April 19th 2021, the EMMI implemented changes to the Euribor benchmark calculations resulting from the yearly benchmark review. 3 of the 4 measures taken, reduce the volatility in times of market stress. As the measures impact the level 3 quote methodology, which is more frequently used in times of stress. This has further reduced the short-term market responsiveness of the benchmark.
Reaction to market developments
Maybe less clear, therefore highlighted by the circles, the new reference rate doesn’t necessarily react in the same way to market developments. This becomes more obvious when the weight of the tails of the distribution are calculated. This skew is a measure of the shortfall, or of the tail risk. It different between the two rates.
Conclusion
Starting October, EONIA will be a fundamentally different benchmark reflecting the market in a different way. And unless pricing, capital and hedging models have all taken this into account, which probably didn’t happen due to a lack of available data and time. It would be wise to keep a keen eye out on how the rates and margins will develop, so you can adjust in time.
I don’t expect a short-term disaster, as the bazooka from Frankfurt is still pinning down all rates to zero. But even so, I’d advise you to fundamentally review all your models built on EONIA before trusting them with ESTER.
Context
EONIA is one of the 3 major reference rates used in Europe. The biggest is EURIBOR. EONIA is second with over a fifth of the volume of EURIBOR and mainly used by short-term markets, followed closely by LIBOR-EUR. The latter is mainly used in the UK in the role of EONIA for the continent. How the EURIBOR reference rate reform will develop is unknown today. But as similar changes are proposed as to EONIA, I expect a comparable impact on benchmark behaviour.
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