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The New EURIBOR Gets Through a Challenging 2020 EURIBOR The new EURIBOR gets through a challenging 2020 In the aftermath of the financial crisis, regulators proposed a new methodology for calculating EURIBOR. Despite the volatility wrought by COVID-19, this methodology performed well in 2020, reflecting expectations for benchmark rates and perceived bank credit risk and capturing the indirect effects of the dislocation sustained in the FX swap market. José Manuel Amor Abstract: The onset of the global financial interbank lending market at different tenors. crisis in 2008 forced regulators and Despite the volatility wrought by COVID-19 supervisors to rethink the suitability of the in 2020, it is fair to say that the EURIBOR IBORs as benchmark rates of interest. In has surmounted a very challenging year, Europe, the FSB’s recommendations affect helped significantly by a new hybrid two key benchmark rates – EURIBOR and calculation methodology developed in the EONIA – and have resulted in the creation aftermath of the financial crisis. Specifically, of the euro short-term rate, or €STR, to replace the EURIBOR rates trended in a manner the EONIA following a period during which the that was consistent with expectations for two indices will co-exist. Importantly, benchmark rates and perceived bank credit EURIBOR must at all times and in differing risk and captured the indirect effects of the market conditions reflect the cost to banks’ dislocation sustained in the FX swap market of obtaining funding in the euro unsecured as a result of the surge in global demand 49 “ The loss of liquidity and trading volumes in the interbank markets made it harder to calculate IBORs based on actual transactions. ” for dollar funding in the early stages of the the decline in liquidity in the interbank COVID-19 crisis. unsecured funding markets), the G20 spearheaded the global reform of reference rates in 2013. The G20 tasked the Financial Backdrop for the reform of the Stability Board (FSB) to establish guidelines interbank offered rates (IBORs) and recommendations for creating a new set For decades now, the interbank offered rates of regulations that could address the current (“IBORs”) have constituted the benchmark system’s shortcomings and correct the issues interest rates for unsecured interbank lending implicit in prevailing reference rates. In 2014, at different maturities or tenors. Those rates the FSB recommended: (i) reinforcing the layer unsecured bank credit risk on top of the methodology used to calculate the reference risk-free rates and have historically provided indices, tying them wherever possible to a benchmark for setting the prices of a very real transactions and improving data supply broad range of financial contracts (loans, processes and controls (the basis for the so- derivatives and fixed-income securities). called “IBOR reform”); and, (ii) identifying alternative risk-free reference rates. The onset of the global financial crisis in 2008 forced regulators and supervisors to rethink The replacement of the IBORs with new the suitability of the IBORs as benchmark reference rates means most calculations of rates of interest. Their construction via IBORs will cease between December 2021 surveys and non-binding rates left them open and June 2023. [1] In Europe, the FSB’s to manipulation. The loss of liquidity and recommendations yielded Regulation (EU) trading volumes in the interbank markets 2016/1011, known as the EU Benchmark Rates made it harder to calculate them on the basis Regulation, or EU BMR. The EU BMR affects of actual transactions. As well, the distribution two key benchmark rates – EURIBOR and of bank credit risk undermined the ability of EONIA [2]– and has resulted in the creation IBORs to reflect common counterparty risk. of the euro short-term rate, [3] or €STR, to Lastly, the concentration of bank funding replace the EONIA following a period during in lower-risk segments (repos) reduced the which the two indices will co-exist. relevance of the interbank lending market. A new method for calculating the In response to scandals over the manipulation EURIBOR rates was rolled out in of IBOR contributions by the banks 2019 participating in the panels, coupled with The European Money Markets Institute the fact that IBORs were determined (EMMI) administers the current and former almost exclusively on the basis of the expert [4] EURIBOR and EONIA rates. Under the judgement of those participants (due to EU BMR, the EMMI has been the official The EU Benchmark Rates Regulation (BMR) affects two key “ benchmark rates – EURIBOR and EONIA – and has resulted in the creation of the euro short-term rate, or €STR, to replace the EONIA. ” 50 Funcas SEFO Vol. 10, No. 1_January 2021 The new EURIBOR gets through a challenging 2020 administrator of the EURIBOR rates since the integrity and reliability of the EURIBOR July 2019. As such, it is obliged to define and rates. The EMMI’s current methodology – still implement a robust system of governance provisional – for determining the EURIBOR and set of control mechanisms to ensure rates is summed up as follows: Exhibit 1 How EURIBOR rates are determined using the EMMI’s hybrid methodology Does the panel bank have sufficient eligible transactions for the tenor in question? Level 1 Does the panel Calculation of the bank have sufficient Yes average rate weighted Level 1 eligible transactions by the volume of contribution for the tenor in eligible transactions question? No No Level 2 Yes Does the bank have Yes Calculation of the Is the tenor 1, 3 or 6 Level 1 adjusted interpolation for Level 2.1 months? contributions for the tenor using spreads contribution adjacent tenors? No No Are there Yes Is there enough Yes transactions at non- transaction volume Calculate the inferred Level 2.2 standard maturities at that maturity? rate for that tenor contribution nearby the defined tenor? No No Did the bank have a Yes Is the tenor 1, 3, 6 Yes Calculate the market rate Level 1 contribution or 12 months? Level 2.3 adjusted for the most contribution at that tenor in recent recent contribution days? No No Level 3 Use a combination based on: (i) two sources of data: additional Level 3 contribution transactions for the Underlying Interest; and/or documented models; and/or (ii) expert judgement to determine a contribution rate Source: Afi, based on EMMI. 51 Although the new EURIBOR methodology continues to rely on the panel “ banks’ expert judgement, it only does so as a last resort, in an orderly fashion and governed by documented models and procedures. ” ■ The methodology is based on contributions banks’ contributions following Level 1 and by a group of credit institutions – the panel 2 rules by using individual transaction banks – that participate actively in the data provided by the latter. In the absence euro money markets. The number of panel thereof, given the diverse composition of banks [5] must be sufficient to constitute a the EURIBOR panel of banks (designed representative sample for the purposes of specifically to capture the geographical determining an average rate and to reflect diversity of the euro money market), each activity in the unsecured euro money panel bank is responsible for determining market. its individual Level 3 contribution. ■ Every day, each panel bank’s final Although the new EURIBOR methodology contribution to each tenor is determined continues to rely on the panel banks’ expert using a hierarchical or waterfall approach. judgement, it only does so as a last resort, in an To the extent possible, the EMMI strives to orderly fashion and governed by documented ground EURIBOR in euro money market models and procedures. The new hybrid transactions that reflect the Underlying methodology is, nevertheless, still in the Interest [6] at the defined tenor from the testing phase, which means it could be subject prior TARGET day (Level 1). When it is not to certain adjustments. This would require possible to arrive at a result based on actual publicly consulting the market participants in transactions, the calculation uses a defined the event the changes prove material. range of formulaic calculation techniques provided by EMMI (Levels 2.1, 2.2 and 2.3) EURIBOR, risk-free rate + bank based on transactions in the Underlying credit risk: A technical aside Interest across the money market maturity spectrum and from recent TARGET days. Before getting into our analysis of the trend in Lastly, if it is not possible to obtain Level EURIBOR rates in 2020, it is worth making 1 to Level 2.3 results, the calculation relies a technical detour to review the various on contributions from the banks based on instruments in the money market and their transactions in the Underlying Interest interrelationship (EURIBOR, the risk-free and/or other data from a range of markets interest rates, the interest swaps written over closely related to the unsecured euro money them and forward rate agreements or FRAs). market, using a combination of modelling techniques and/or the panel bank’s EURIBOR must at all times and in differing judgement (Level 3). market conditions reflect the cost to banks’ of obtaining funding in the euro unsecured ■ Based on this new methodology, the EMMI interbank lending market at different tenors. is tasked with determining the panel Given the existence of counterparty risk in Given the existence of counterparty risk in respect of the principal “ and interest, the EURIBOR rates should trade at a spread over the risk-free rates with the same maturities. ” 52 Funcas SEFO Vol. 10, No. 1_January 2021 The new EURIBOR gets through a challenging 2020 The overnight risk-free reference rate is the €STR, which is calculated “ and published by the ECB and reflects the wholesale euro overnight borrowing cost of banks located in the eurozone. ” respect of the principal and interest, the the eurozone.
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