A new paradigm? – Risk Free Rates (RFRs)

Dr. Andreas Engelmann M.Sc.1, Dr. Simon Heil2, 29 November 2019

FCA’s announcement in July 2017 – stating that it will not compel or persuade panel banks to make LIBOR3 submissions after the end of 2021 – unleashed a flurry of activity around not only choosing alternative reference rates but also developing the roadmap needed for transitioning to new RFRs.

Several national working groups have since then put tremendous effort into finding new benchmark RFRs for their respective monetary zone. A summary of the current status quo for the major currencies can be found in the following table:

 

Currency

Working Group

Alternative RFR

Publication date

USD

Alternative Reference Rates Committee

Secured Overnight Financing Rate (SOFR)

April 2018

GBP

Working Group on Sterling Risk-Free
Reference Rates

Reformed Sterling Overnight Index Average (SONIA)

April 2018

JPY

Study Group on Risk-Free Reference Rates

Tokyo Overnight Average rate
(TONA)

December 2016

CHF

National Working Group on CHF Reference Rates

Swiss Average Rate Overnight
(SARON)

August 2009

EUR

Working Group on Risk-Free Reference
Rates for the Euro Area

Euro Short-Term Rate (ESTER/€STR)

October 2019

 

An important feature for all currencies except the Swiss franc is that the range of eligible transactions is no longer limited to interbank lending/borrowing activities but includes interest rates between banks and non-bank lenders/borrowers. The US and Switzerland have further opted to base the secured overnight financing rate (SOFR) and Swiss average overnight rate (SARON) on secured transactions (repo) thus incorporating credit worthiness.
Choices between unsecured and secured RFRs have to a large extent been made based on liquidity and structural features of the underlying money markets.

 

€STR and the “old” EONIA: The dynamic duo

Contrasting to the other currencies, the Euro zone sticks to two RFRs – at least until June 2020 – namely the previously mentioned €STR and in addition the Euro Overnight Index Average (EONIA4). These two being dependent through a fixed spread EONIA = €STR+8,5bps. This is a simplified adjustment based on historical average data from 17 April 2018 to 16 April 2019. This dependency holds until the decommissioning in June 2020. As of 02 October 2019, only €STR will be calculated according to criteria differing from the previous EONIA calculation method.

The product range referring to the “old” EONIA includes variable loans in all forms, interest rate and credit derivatives and even bonds. But more importantly, the entire collateral management of exchanges, clearing brokers and central counterparties5 and bilateral CSAs6 are based on EONIA. EONIA will continue to be published for a certain transition period, until 3 January 2022, after which publication will be completely discontinued. This will provide time to make appropriate adjustments to existing transactions and to get used to €STR.


€STR vs. the “old” EONIA: Mind the details

There are significantly more differences between the new €STR and the previous EONIA than just the name or the fixed spread of 8.5 bps. This has a small but subtle influence on the whole yield and credit spread curve construction process in many models applied today, most importantly:

  • The calculation basis itself is different. EONIA is based on quotes from a limited number of banks via their unsecured interbank overnight money business. €STR, on the other hand, is based on reported unsecured fixed rate deposit transactions in the interbank market with a nominal value of at least one million euro. The transactions are volume-weighted in the €STR.
  • EONIA is currently published on the same day, always at 19:00 Central European Time. €STR will be published with T+1, every TARGET business day at 8:00, followed by EONIA-new at 9:15 in the morning. The comparatively long-time delay between €STR and EONIA is due to the revision procedure for the €STR. Should errors occur in the calculation of the €STR having an effect of more than 2 bps, €STR could be corrected again at 9am.
  • Changing to T+1 implies that no reference interest rate can be published on 1st October and EONIA is last calculated and published on 30 September according to the old method. For fixings on 01 October 2019, the last available EONIA must be used.
  • €STR is published directly by the ECB while EONIA was previously calculated and published by EMMI (European Money Markets Institute). EMMI will continue to calculate the new EONIA, i.e. €STR+8.5bps.
  • Should ECB raise or lower the key interest rate, the calculation of the €STR is adjusted to take into account the new key interest rate and the rate corridor. This is necessary because the €STR is based on yesterday’s transactions, whereas €STR fixings apply to the respective publication date.


€STR and the “old” EONIA: Systems, products, valuations and yield curves

Transitioning from EONIA to €STR does not seem to be that complex, nonetheless it will require readjustments of numerous functional processes. What could be difficult for systems and processes is, above all, switching from same day to T+1. Moreover, throughout the transition period there will be a parallel universe of products encompassing a decreasing number of products relating to the old EONIA and an increasing number being based on €STR. Hence, the complete business cycle incl. regulatory/internal reporting should be able to deal with those products simultaneously. Finally, in case of jumps or irregularities around the decommissioning time of EONIA in June 2020 within e.g. hedge effectiveness, regulators/auditors will ask for explanations.

€STR and EONIA swaps cannot be netted against each other as they will each have their own product codes/identifiers. Furthermore in a time of central clearing, the question arises how quickly and how well the new €STR swaps will be integrated into the clearing processes and systems. LCH cleared the first €STR swaps in October 2019 while Markit is said to have settled the first SOFR swap in July 2019. EUREX Clearing is said to have amended their CSA to incorporate the new RFR to become effective in November 2019.


RFRs: The term structure conundrum

It is not yet clear how term structures for the new RFRs will be derived7 and whether it will be a forward-or-backward-looking methodology or how an average rate can be calculated (simple or compound interest). Differences in the level of preparation vary between derivatives and cash markets. LIBOR/EURIBOR is available in various tenors, while the new RFRs are limited to overnight rates. Derivatives markets rely heavily on LIBOR/EURIBOR, primarily in the OIS-swap markets. Thus, they should be able to transition to the new RFRs more readily. By contrast, cash markets (incl. bond issuers and lenders) commonly use forward-looking term structures which allow counterparties to project coupon and interest payments at the beginning of the contract term. Developing term rates is the next stage of the work to be carried out by the respective working groups. Firms that do not require term rates should plan their transitions using the overnight RFRs.

In conclusion, transitioning to the new RFRs will not be like any other transformation program that firms have undertaken this century. The risks are significant and while firms may consider 2021 to be a long way off, the complexity and scope of the task ahead allow no room for complacency or inertia. The level of scrutiny will continue to grow and consequences are to be feared if progress does not happen fast enough (or at all). To ensure that our clients have identified all relevant risks and are managing them in an appropriate way, a small but well-equipped team at pdv Financial Software GmbH is keeping up with the most recent developments concerning the new RFRs and is readily available to support our clients with their transition to post-LIBOR/EURIBOR.

 

1 Physicist & Financial Mathematician, Freelance Consultant
2 pdv Financial Software GmbH
3 Inter-Bank Offered Rate (IBOR) is used as reference rate or benchmark of the average rate at which banks are borrowing from one another in the short-term money markets. LIBOR is one of many interbank offered rates currently in use. It is calculated daily based on rates quoted by a panel of banks for five currencies and across seven maturities.
4 Until October 2019 the EONIA rate used to be the 1-day interbank interest rate for the Euro zone. In other words, it is the rate at which banks provide loans to each other with a duration of 1 day
5 Margin and PAI calculations and the complete hedge accounting, esp. retrospective/prospective effectivity reports. Switching to a new RFR could lead to jumps within the hedge effectivity that need to be explained to the regulator/auditor.
6 Credit support annex governing eligible collateral, the corresponding rates and payment method
7 Cf. FSB Overnight Risk-Free Rates, A User Guide, 4 June 2019

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