ECB’s Holthausen urges market to ditch Eonia

Regulator sees risk in relying on fallbacks to effect switch to €STR – and calls on dealers to educate clients

ECB-Eurotower-in-Frankfurt

A senior European regulator has urged the market to embrace the euro short-term rate, or €STR, after market participants abandoned the new benchmark in favour of the outgoing Eonia during Covid-19 volatility in March and April.

Volumes in €STR have started to recover – and should have received a shot in the arm when clearing houses started using the new rate to discount cleared euro interest rate swaps in July – but they remain lacklustre.

“I would have hoped for more activity at this point,” said Cornelia Holthausen, deputy director-general for general market operations at the European Central Bank. “Activity had been higher before the pandemic kicked in, but when you had the market uncertainty and special market circumstances, the market was firmly moving back to using Eonia.”

Holthausen was speaking on a Risk.net webinar on September 23 (available to play back here).

She warned participants to start the necessary preparations and repapering to begin trading the new risk-free rate and transition Eonia books well ahead of January 2022, when the legacy overnight rate will be decommissioned. The alternative is to hope that contractual amendments will safely switch those trades to the new rate.

“I think it bears some risks if people wait until the very last day and rely on all fallback clauses to operate as expected and all systems and processes to continue to work flawlessly,” Holthausen warned. 

She added that dealers and other larger market participants have a “responsibility” to educate their clients and steer the market away from Eonia: “I would encourage everyone to use the euro short-term rate and also implement the switch from Eonia. Don’t wait until the last minute – do the repapering that’s necessary and start doing it now.”

Trading in swaps linked to €STR has waxed and waned since the Euribor replacement launched in October 2019. At LCH, cleared monthly volume in the instruments hit a high of €170 billion ($198 billion) in February, but has since tumbled. In May, the clearing house registered just €9.45 billion of the instruments.

I think it bears some risks if people wait until the very last day and rely on all fallback clauses to operate as expected
Cornelia Holthausen, European Central Bank

Activity has since increased, but a July 27 switch to using €STR as the discount rate for valuing cleared euro swaps has not yet had the hoped-for impact. In August – the first full month for trading under the new discounting regime – just $65 billion equivalent of the instruments were registered at LCH, 14% down on the previous month.

“There has been no shift away from Eonia as the dominant label that people trade,” said Philip Whitehurst, head of service development for rates at LCH, also speaking on the webinar.

He added that 95% of euro-denominated overnight indexed swaps (OIS) are still being traded in Eonia – some of it extending well beyond the date for the rate’s demise.

Meryeme Souilmi, head of G10 rates derivatives trading for Europe at Societe Generale, has also seen little shift to-date. “We haven’t seen a change in the way to request swaps versus an OIS-like reference. We see as much Eonia as before the switch,” she said on the webinar, noting there have also been some increased requests for €STR as market-makers attempt to promote the new rate.

Fungible benchmarks?

Incentives to switch are limited. Unlike Libor, which faces the axe at the end of 2021, Euribor – the primary term interest rate for euro derivatives markets – could stick around indefinitely. Speaking at an industry event on Tuesday, Steven Maijoor, chair of the European Securities and Markets Authority, which will oversee Euribor from January 2022, confirmed a discontinuation of Euribor “is not part of our plans.”

While Eonia will end in just over a year’s time, a fixed spread between the legacy overnight rate and its replacement means many participants view the two risks as almost identical. At €STR’s October 2019 launch, Eonia was recalibrated as a fixed spread over the new – more robust – rate.

“Since we have a fixed spread of roughly 8.5 basis points between Eonia and €STR, both risks seem equivalent. That’s why we see a lot of banks that are adopting fungible limits, which means whether you trade on Eonia or €STR, they are added to the same bucket of risks,” said Jean-Christophe Machado, interest rate strategist at Natixis. “Eonia swaps are becoming some kind of €STR product with an Eonia stamp on it. So basically, it’s a labelling problem now.”

He added take-up of the new rate has varied across Europe, with clients in German and Italy making the move earlier while clients in France lag behind.

Cornelia-Holthausen-2019
Cornelia Holthausen: The switch “shouldn’t be underestimated”

LCH applies almost identical margin levels to the two rates, which are treated as the same risk factor, Whitehouse confirmed. What’s more, cleared Eonia swaps benefit from an explicit fallback, which will see the contracts rehitched to €STR following Eonia’s demise.

Holthausen warned participants not to rely on fallback clauses and instead make a gradual move towards the new rate.

“It shouldn’t be underestimated that the switch, while maybe being only a labelling problem or a system issue, will require a lot of work,” Holthausen said.

She added these risks should be mitigated if market participants prepare in advance to begin using €STR on a regular basis and called on larger players to educate their clients about the potential risks of trading Eonia contracts in maturities beyond the rate’s lifespan.

“It’s important that the bigger market players who understand these transition issues have a certain responsibility to take the initiative and educate the smaller players in the sense that they incentivise them to start internal preparations and make the necessary changes to their system.”

LCH is preparing to engage with clients on possible conversion mechanisms that could help participants flip legacy cleared Eonia contracts to €STR before fallbacks are triggered, Whitehouse said.

“It’s something we need to raise as a priority,” he said. “It’s our job to make sure we support the trading that goes on in the marketplace, but I think we need to up our focus on the potential transition arrangements that might need to apply.”

Prospects for term €STR

The introduction of a forward-looking €STR term rate could help bolster liquidity, according to Machado at Natixis. The ECB is considering term €STR proposals from three providers: FTSE Russell, Refinitiv and a combined effort between the European Money Markets Institute and Ice Benchmark Administration. All propose to build the rates from OIS quotes – a blueprint being trialled in the UK for term Sonia. IHS Markit, which proposed an alternative methodology, has since dropped out of the race to build term-RFRs.

The quote-based methodology may be popular but comes with a classic chicken-and-egg problem – thin liquidity in €STR derivatives could hamper attempts to build the term benchmark.

“Maybe [with a term rate] we could see more €STR-linked issuance, but we might need a bit more liquidity on the swaps to achieve a term structure on €STR. Maybe we need a milestone before a term rate,” said Machado.

The bigger market players… have a certain responsibility to take the initiative and educate the smaller players
Cornelia Holthausen, European Central Bank

Given the fixed spread that exists between Eonia and €STR, SocGen’s Souilmi sees no problem creating an €STR term structure from current trading activity.

“Eonia is a very mature market, liquidity is plenty and it’s very easy to source liquidity all across the curve,” Souilmi said.

“For me, the market is super mature. For three-month €STR, everyone knows where it is, all the screens are the same, market-makers have the same prices. There’s no doubt the market is liquid enough. It’s more a matter of how to use it and how the market would transition to a new way of using the benchmark.”

Holthausen disagreed, casting doubts over the long-term prospects for a robust term €STR.

“If you want to have a robust rate, currently even taking into account the Eonia volumes, it’s not enough at this point in time. No one knows when or whether it will ever be sufficient to have a robust and reliable rate. We think, at the ECB, backward-looking rates are superior.”

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