The global effort to replace interbank offer rates (IBORs) with risk-free rates (RFRs) represents the most significant challenge faced by financial markets in decades. To date, the brightest spotlight has been on Libor, the suite of IBORs published in London, which is set to be discontinued at the end of 2021. Libor is published for five G10 currencies, four of which (GBP, USD, JPY and CHF) use it as the primary benchmark for their rates markets. As a result, Libor underpins contracts with a notional value of over $350 trillion – more than four times the world’s total GDP.
That said, Libor is not the only game in town. As of February 2019, the European Central Bank (ECB) estimated that Euribor, the primary benchmark for the EUR rates market, is referenced in contracts with a total notional of €109 trillion. And just like its London counterpart, Euribor also faces a very uncertain future.
Impact of the EU Benchmark Regulation
In the Eurozone, the transition away from IBORs is largely driven by the EU Benchmark Regulation (BMR). First published in June 2016, the BMR aims to ensure that indices used in financial instruments and contracts are accurate and reliable. As such, from 1st January 2022, only benchmarks published by “authorized administrators” will be permitted in new financial contracts. Unfortunately, accuracy and reliability are two qualities that many believe are not shared by IBORs, due to their reliance on an interbank lending market that all but dried up in the aftermath of the financial crisis. As a result, significant doubts have been raised over whether the European Money Markets Institute (EMMI), which publishes Euribor, would get authorization to continue to do so.
Unlike Libor, however, Euribor is not necessarily destined for the bin. In response to the publication of the BMR, EMMI announced a series of reforms for Euribor. Under the new proposals, Euribor’s calculation would no longer rely purely on “expert judgment” (a significant bugbear in the BMR), but would be primarily based on actual transactions in the underlying interbank lending market. Only if such transactions were unavailable would EMMI revert to using estimates submitted by a panel of banks. This new hybrid version of Euribor underwent a testing phase in 2018, and EMMI expects to submit it for regulatory authorization later this year.
Time for Plan B?
Nevertheless, it would be a brave company that relied on Euribor being successfully reformed without developing a Plan B. At root, no new calculation methodology can make up for the fact that Euribor’s underlying market simply doesn’t exist in anything like the volume that it used to. This means that EMMI’s authorization is very far from being a foregone conclusion. Even if successful, it could be revoked at a later date if the interbank lending market deteriorated further. Market participants are currently divided over whether the benchmark will be discontinued immediately in 2022 – but even those who expect the status quo to continue do not think it will hold for long.
As a result, the situation for Euribor may soon resemble that for Libor. In practical terms, this would mean renegotiating all contracts that reference Euribor so that they are based on an overnight RFR instead. On the plus side, the ECB is in the final stages of preparing such an RFR for the Eurozone: ESTR, or the Euro Short-Term Rate, will be published from October 2019. That said, given the current uncertainty over Euribor’s future, EUR borrowers and users of derivatives may end up with significantly shorter transition timelines than those in other markets.
With only two and a half years to go until the BMR’s deadline, a higher degree of clarity from regulators would be hugely valuable for the EUR rates market. Users of Libor were given four and a half years’ notice of its planned discontinuation. Under the present timeline, should Euribor be discontinued, users will get less than two years’ notice. This is clearly far from ideal. It therefore makes sense for borrowers and derivative users to start thinking about how they would need to adjust their financing arrangements in a world without Euribor. As ever, the firms that put in early preparation will be the ones to navigate the transition most successfully.
Upcoming economic data
It is set to be a quiet week for economic data, although Friday will see the publication of the final UK GDP growth figures for Q1 2019. No change is expected from previous estimates of 1.8% YoY.
For more information, please contact Joshua Roberts, Associate Director at JCRA, at firstname.lastname@example.org.