The LIBOR scandal came to prominence in 2012 after a series of interest rate actions that were considered manipulative. Since then, interest rate benchmarks have been under scrutiny across global financial markets. This has led to various proposals for reforms or replacements of interest rate benchmarks that serve as a reference rate for standardized interest rate derivative contracts.
The working group on euro risk-free rates, an industry group established in 2018 by the European Central Bank (ECB), the Financial Services and Markets Authority in Belgium, the European Securities and Markets Authority (a regulatory and supervisory body based in Paris), and the European Commission, was tasked to identify and recommend risk-free rates to serve as an alternative in the euro area. On Sept. 13, 2018, the working group recommended European investors switch from EONIA, the euro's current overnight reference rate, to the proposed new euro overnight benchmark rate, the Euro Short-Term Rate (€STR). The ECB, the administrator of the €STR, will start publication on Oct. 2, 2019.
In our view, the €STR benchmark is consistent with our criteria and, as such, we would not classify the issued investments using this benchmark a "higher-risk investment." Below, we answer questions about how EONIA and €STR are different, and how we would treat €STR under our current principal stability fund ratings (PSFR) criteria (see "Principal Stability Fund Rating Methodology," published June 23, 2016).
Frequently Asked Questions
What is the difference between EONIA and €STR?
EONIA and €STR have one common feature in that they both rely on transactions from the euro-denominated overnight-unsecured money market segment. However, they do differ in several ways (see table).
| Differences Between EONIA And €STR | |
|---|---|
| EONIA | €STR |
| EONIA is administrated by the private sector via the European Money Markets Institute (EMMI) | €STR will be administrated by the ECB |
| EONIA relies on voluntary data input by 28 panel banks, with one contribution per bank | €STR will be built on the daily data submissions of the 52 banks reporting in accordance with the money market statistical reporting (MMSR) regulation |
| EONIA is a weighted average rate of the submitted contributions | €STR relies on individual transactions rather than on a single contribution per bank |
| Calculated using unsecured overnight interbank lending transactions | €STR is based on unsecured overnight wholesale borrowing deposit transactions |
| Average daily volume is €4.6 billion | Average daily volume is €33.5 billion |
How will the market transition from EONIA to €STR?
EONIA will become an €STR plus spread to help facilitate a transition to the new euro risk-free rate. Based on the average daily spread from April 17, 2018, through April 16, 2019, the ECB has calculated the spread at 8.5 basis points (bps). The spread is the economic difference between the interbank lending rate and the wholesale borrowing rate. From Oct. 2, 2019, the publication date of €STR, EONIA will be modified and published at a rate of €STR plus 8.5 bps until Jan. 3, 2022, its discontinuation date. Market participants are expected to fully adopt the new euro risk-free rate by the end of EONIA's last publication date.
How do we view index and spread risk for principal stability?
Variable-rate notes (VRNs) or floating-rate notes (FRNs) used in money funds are typically linked to conventional money market indices, providing funds with yields that track short-term interest rate movements. These investments are designed to exhibit less interest rate risk than fixed-rate investments, but this is not always the case. Factors affecting the value of these instruments include index risk and spread risk.
Index risk is the possibility that the coupon of a VRN or FRN will not adjust in tandem with money market rates. Index risk can be introduced by calculating the variable-rate coupon based on a non-money market index, a money market index in which the coupon adjusts based on a multiple (or fraction) of the index, or an index based on the difference (or spread) between two or more indices.
When analyzing VRNs and FRNs in money market funds, we compare the index used in the variable-rate adjustment formula to a standard money market index assessing that these instruments can introduce potential price volatility to assets commonly held by funds assessed for principal stability.
We typically consider products "higher-risk investments" when tied to indices that introduce credit risk or other spread risk and whose historical volatility was not able to support a correlation of 95% to a core local currency anchor money market reference rate over a sustained period. Characteristics of anchor money market reference indices include an established trading history, market acceptance, typically a maturity profile within one year, and performance commonly reflective of the movements in short-term money markets in the local currency.
What are the key components of a money market index, according to our criteria?
We look at the following factors when we assess an index related to VRN/FRN investment using our PSFR criteria.
Correlation. Unusual for our 95% index correlation assessment is that €STR and EONIA do not indicate a correlated relationship between each other. Correlation against other anchor money market reference rates are also well below the 95% threshold. However, in our view, the calculation and reporting agents are different between €STR and EONIA. Therefore, to review the viability of €STR pertaining to money market funds, we need to assess the underlying qualitative aspects of the benchmark rate.
Established trading history. While €STR has not been officially published, calculations based on pre-€STR data show there is a significant size advantage when comparing the volume of transactions. Looking at the market share (the sum of volume), pre-€STR accounts for, on average, 88% of the transactions compared to 12% for EONIA, from March 15, 2017, through July 30, 2019. Additionally, the trend has been increasing in favor of pre-€STR.
Chart 1
Chart 2
Market acceptance. €STR is International Organization of Securities Commissions (IOSCO) and EU Benchmark Regulation (EU BMR) compliant, while EONIA is not. EONIA has too few transactions and market participants contributing to its calculation, which has led to increased concentration and volatility risk. Given €STR will rely on a more diversified group of financial participants, pre-€STR volume data has been significantly higher than EONIA.
Chart 3
Typically a maturity profile within one year. €STR will be an overnight rate. The ECB will not provide a longer-term reference rate beyond an overnight maturity at this time. However, the working group is identifying fallbacks for EURIBOR based on €STR. The recommendation for a term-structure methodology would incorporate (tradable) overnight index swap (OIS) quotes.
Performance commonly reflective of the movements in short-term money markets in the local currency. €STR requires mandatory data from 52 banks, where banks will submit individual transaction data daily. The rate will be based on unsecured overnight borrowing deposit transactions. Additionally, €STR reflects the borrowing cost of the wholesale market, including money market funds, insurance companies, and other financial corporations, instead of just banks. Having a wider market of transactions and a large selection of banks will allow the rate to be more robust and less concentrated. Lastly, trends in the daily volume of transactions have been trending upwards.
Comparatively, EONIA relies on voluntary data from a panel of 28 banks, with one contribution per bank. EONIA is a weighted average rate of the submitted contributions calculated using unsecured overnight lending transactions. The rate reflects the average cost of the unsecured overnight interbank lending market. The volume of transactions based on EONIA have been trending downwards.
This report does not constitute a rating action.
| Primary Credit Analysts: | Andrew Paranthoiene, London (44) 20-7176-8416; andrew.paranthoiene@spglobal.com |
| Andrew Bae, New York + 1 (212) 438 0332; andrew.bae@spglobal.com |
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