The reform of interest rate benchmarks: challenging financial stability, by María José Gómez Yubero

"The data show the need and importance to step forward in the awareness of the industry and in its preparation to face the challenges of the transition. All stakeholders, both private and official sector, have their own responsibility in this challenge."

Interest rate benchmarks play a crucial economic role in the pricing of many instruments and contracts, in risk management as well as in the implementation and monitoring of the monetary policy. The overall exposure to both Libor and Euribor is estimated at around EUR 200 trillion, while Eonia is estimated to be EUR 6 trillion. In Spain, the contracts referenced to Euribor represent more than four times the Gross Domestic Product and more than double those referenced to Libor, being the exposure via retail mortgages especially relevant.

Current benchmark reform stems from past cases of manipulation of the interbank rates, commonly known as ibors, which showed their vulnerability and the adverse effects that they can have on financial stability. The reduction in the activity in the money markets produced since the financial crisis has also questioned their sustainability in the medium and long term.

Therefore, the G20 and the FSB (Financial Stability Board) have encouraged reforms (in the European Union they have led to Regulation (EU) 2016/1011, directly applicable from January 1, 2018) in order to move towards improved benchmarks, less vulnerable to manipulation and more representative of the economic reality that they measure, as well as towards alternative risk free rates that reduce the excessive reliance on ibors.

In the eurozone, the European Central Bank has decided to develop a short-term euro interest rate (Ester, Euro ShortTermRate) starting in October 2019. Ester will reflect the wholesale euro unsecured overnight borrowing costs of euro area banks. This rate has been recommended as the risk-free rate in the euro area and as a replacement for Eonia, whose use will be restricted as of January 1, 2020, as it will no longer meet the criteria of Regulation (EU) 2016/1011.

Ester will also serve as a fallback rate for contracts linked to the Euribor, which must include fallback clauses to contemplate the eventual disappearance of the benchmark.

Since 2013, EMMI, the administrator of the benchmarks in the eurozone, has been working on the implementation of a methodology for determining the Euribor based on real transactions to replace the current one based on quotes from a group of banks. In 2016 EMMI carried out an exercise to verify a fully transaction-based methodology that was not feasible. Since May 2017, EMMI has been developing a hybrid methodology for the calculation based on transactions of these banks, whenever available, and relies on other related market pricing sources when necessary to determine their cost of funding. This new methodology has recently been tested. The Belgian supervisor, responsible for its authorization, has qualified the results of the testing as a significant step towards compliance with EU Regulation.

In the United Kingdom, the Bank of England has already introduced the SONIA (SterlingOvernightIndexAverage) that must replace the Libor, whose survival is not expected beyond 2021, the date on which the British authorities have announced that they will no longer support the benchmark and will allow the panel banks to leave the panel if they wish.

These measures are added to those taken in other jurisdictions such as the United States, Switzerland or Japan where the process of disposition of alternative rates has also begun and where work is being done to facilitate the transition towards an environment with greater diversification in interest rates and less dependence on ibors.

The reform of interest rate indexes and the transition to new alternative rates is complex and difficult and grants exceptional challenges for market participants due to their global nature.

The geographical extension, the range of companies, clients, contracts, instruments, processes, and services involved require a proactive attitude and adequate preparation of the market to face such challenges successfully.

The euro area is specially conditioned by too short deadlines and by some issues still to be resolved: the availability of suitable indexes for the different current uses, a curve backed by a sufficiently deep and liquid market and the issues raised by the renegotiation of the contracts.

The challenges are relevant and must be managed proactively to avoid interruption or discontinuity of the indexes or an incomplete transition that could lead to disturbances for the markets and their participants, including the end users, as well as for the financing of the economy and financial stability.

The risk assessment report of 2018 published by the EBA (EBA Risk Assessment of the European Banking System, December 2018) reveals that 85% of banks are aware of this challenge and working on the replacement of ibors.

However, a recent survey conducted in the United Kingdom, where the progress of the reforms is notably higher than that of the eurozone, indicates that only 2% of the entities have renegotiated the contracts referenced to Libor. The study carried out by the consultancy JCRA among banks, investment funds, asset managers and non-financial corporations, indicates that there are also delays in the negotiation processes, including the detection of contracts that may be affected by the change.

These data show the need and importance to step forward in the awareness of the industry and in its preparation to face the challenges of the transition. All stakeholders, both private and official sector, have their own responsibility in this challenge.

All these topics will be discussed in the conference Cycle “Reform of interest rate benchmarks: latest developments and next steps” organized by FIDE, which will be held at the headquarters of Fide on 21st of January, 18th February and 25th March 2019.

María José Gómez Yubero

The reform of interest rate benchmarks: challenging financial stability, by María José Gómez Yubero

Head of Resolution and Financial Stability Issues in the Directorate General of Strategic Policy and International Affairs of the National Securities Market Commission. With extensive international experience, she has chaired and been part of various international groups and has published numerous articles in specialized and general media. Member, representing the CNMV, of the colleges of supervisors of the Euribor, Eonia and Libor indices. Member of the SAREB Monitoring Committee, the EBA Resolution Committee, and the FSB Resolution Steering Group-Fmi CBCM. She also participates in several ESMA and IOSCO committees.

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