EBF expansion of Euribor set to increase euro benchmarks gap

Changes are planned to a key euro rates benchmark - and it could have a number of knock-on effects.

The European Banking Federation (EBF) is looking at expanding the panel of banks that contribute to Euribor fixings to include more peripheral and mid-tier institutions – a change that could nudge fixings higher and alter the relationship between Euribor and other key rate market benchmarks, possibly forcing more hedging activity.

Currently, 43 banks contribute to Euribor, which is the benchmark rate at which prime banks borrow in euros from each other. The make-up of the panel could change later this year.

“I’m leading a study to enlarge the panel to new regions of the euro system. Any changes will be announced around November, but no final decision has been taken,” says Cédric Quemener, the Brussels-based manager of Euribor-EBF.

Quemener claims there is no shortage of applicants should Euribor-EBF want to expand its panel: around 30 banks across the Eurozone have expressed an interest in signing up, and a handful of these are under serious consideration for inclusion. Quemener sees a place for second-tier banks within western European countries, or top-tier banks within central and eastern European countries. He cites Slovakia as an example.

“We believe a prime bank is a player with a large amount of assets, which is active in its local money markets and has a real impact on the rate. Our reason for expanding the benchmark would be to maintain the Euribor benchmark as an accurate reflection of the development of the eurozone,” he says, adding that the Euribor rate could change as a result: “I would be happy if the rate changed a bit – it would mean the new banks were the right ones to introduce to the panel.”

Our reason for expanding the benchmark would be to maintain the Euribor benchmark as an accurate reflection of the development of the eurozone

Changes to the rate are unlikely to be outlandish. The highest and lowest 15% of quotes supplied by the panel are eliminated and an average of the remainder is taken to establish the Euribor fixing. Inclusion of more peripheral banks in the panel should still raise the Euribor rate though, which could have a variety of knock-on effects. Simon Wilson, deputy head of Europe, the Middle East and Asia delta trading at Royal Bank of Scotland in London, says the spread between the cash bond market and the swap market would be likely to widen.

“If Euribor is going to drift up, it may very well push spreads wider between cash bonds and swaps, while Eonia-Euribor basis will widen too. It’s not unusual risk though – this movement is the kind of thing people hedge all the same. Overall, it’s something that might contribute to systematically higher Euribor rates,” he says. 

Permanently higher Euribor rates could cement a recent phenomenon in markets: the widening in the basis between euro Libor and Euribor – two rates benchmarks often thought to measure the same thing, which has crept up over the past six months (see box).

“Any significant expansion to the Euribor panel should bring the average rate slightly higher. It could also be the trigger for the Euribor versus euro-Libor basis to accelerate wider, which might bring more people to hedge their basis exposures,” says Jason Cohen, head of the euro swaps desk at Citi in London.

 

Rates discrepancy - no smoking gun

The European Banking Federation (EBF) began publishing Euribor on December 30, 1998, to coincide with the birth of the euro. It quickly replaced euro-Libor – the British Bankers’ Association’s (BBA) euro lending benchmark – as the de facto discounting rate for euro interest rate swaps.

Historically, the basis between the two rates has been virtually non-existent: in mid-2009, the basis between three-month tenors of Euribor and euro Libor was 1 basis point. This basis has widened over the past year though: on June 30, 2010, Euribor was 8bp higher than euro Libor.

Legacy derivatives trades priced off euro-Libor are the potential casualties of this dislocation. Don Smith, economist at Icap in London, estimates €1 trillion of legacy interest rate swaps are still outstanding, and he says the broker has seen two Euribor-euro Libor basis swaps executed over the past two months, which he believes could have been dealers hedging their basis risk. But traders play down the significance of the dislocation. “I don’t think there is €1 trillion worth of risk. It’s possible not everyone is aware of this basis risk, but I think we’re talking potential profits or losses of tens of millions rather than hundreds of millions of euros for a desk,” says Jason Cohen, head of euro swaps trading at Citi in London.

Icap’s Smith puts forwards various theories to explain the discrepancy between the rates, although there isn’t one smoking gun. “It’s a combination of factors. The EBF and BBA surveys are fundamentally different: it’s largely a different panel of banks that are asked a different question. These differences become exacerbated at times of stress and illiquidity in the money markets. The greater credit risk associated with some of the banks on the Euribor panel is another potential reason. Then there is the influence the European Central Bank’s fixed-rate liquidity operations is having on Euribor, and there is a good chance the basis will narrow to a large extent when the ECB eventually relaxes its control of money-market rates,” he explains. A widening of the Euribor panel, of course, could change the picture.