In European interest rate benchmark transition, the unstoppable force is meeting the immovable object.
The euro swaps market remains steadfastly bound to Euribor, and regulators are showing no signs of prodding the market away from the legacy benchmark.
Yet one set of products – cross-currency swaps – has defied this inertia, with the euro short-term rate, or €STR, gaining momentum as the market standard for the euro leg on interdealer trades.
Some believe this shift could be critical in driving the transition in other parts of the euro rates market, which looks increasingly misaligned with the rest of the world.
Frequent borrowers who use cross-currency instruments to match their foreign currency debt with Euribor liabilities are already paying the price for the fractured approach. The changing cross-currency standard means they must now pay up to cover an increasingly volatile Euribor versus €STR basis.
“A once stable market is now the furthest thing from stable,” says an interest rates trader at a European house. “The cost of a €STR/Euribor hedge is meaningful these days because it’s so volatile. It’s not a positive development.”
Amid rising hedge costs, some of Europe’s largest borrowers, including German agency lender KfW, are mulling wider adoption of €STR on both funding and loan books.
“We are currently in the process of deciding whether it would make sense for KfW to use the interdealer cross-currency swap standard, which is €STR, or continue using Euribor as the relevant steering rate for KfW,” says Markus Schmidtchen, the bank’s head of treasury.
For borrowers like KfW, which made €107 billion ($113 billion) of loans in 2021, the decision to align with cross-currency conventions must be set against lower liquidity in the €STR swap market versus Euribor. The change of approach would also require loan clients to accept an overnight lending benchmark lacking forward payment visibility.
“If you’re a euro issuer and you’ve been swapping to six months Euribor for the last 20 years, I don’t think the emergence of another rate will nudge you to change your practice overnight,” says a benchmark transition manager at a large European bank. “We might see an organic development, but I don’t think we’ll wake up and suddenly find that we’re losing liquidity in six-month Euribor swaps”
What’s more, a backdrop of rates uncertainty and high volatility may scupper short-term efforts.
“From a practical point of view it’s quite a bad moment to move into the direction of risk-free rates. It’s the first time in almost 10 years that we have market movements and that’s not helpful for benchmark transition as a whole,” says Schmidtchen.
While few expect any rapid realignment, some believe the euro market will ultimately fall in line with new global norms.
“The EU has not so much as started to consult on Euribor’s demise. But with all the other jurisdictions having moved to replacement rates, will the EU really stick forever with the last Ibor standing? We give it five years,” wrote Phil Lloyd, head of customer sales delivery at NatWest Markets in a note to clients.
Behind the curve
Sterling, Japanese yen and Swiss franc markets made their final transition to successor risk-free rates at the end of December, when the underlying Libor benchmarks were permanently withdrawn. US dollar markets are in the midst of a phased switch to SOFR, or the secured overnight financing rate, ahead of US dollar Libor’s planned closure after June 2023. Benchmark transition is ongoing in other jurisdictions, including Australia, Canada and Hong Kong.
The eurozone, by contrast, remains in a state of inertia.
With no explicit regulatory push to risk-free rates, lenders and borrowers are sticking with Euribor – a rate which is heavily reliant on panel bank judgement, even after a methodology overhaul.
“The common theme for all of those benchmark transition success stories has been an initiative by a regulator to push clients and the dealer community to trading in the new risk-free rates. There’s been no such push in euro and activity hasn’t really budged,” says Angus McDiarmid, head of European interest rate derivatives at Tradeweb.
Tradeweb data shows €STR accounted for no more than 17% of euro swaps traded on the platform between January and May this year as measured by risk – only a marginal increase on the outgoing Eonia rate it succeeds. McDiarmid attributes this increase to overnight index swaps trading around central bank policy dates.
The euro risk-free rate working group, established by official sector bodies including the European Central Bank and the European Securities and Markets Authority, developed €STR with two aims. One, to replace Eonia, which was deemed too flimsy to meet EU benchmarks regulation and was killed off at the end of 2021. Two, as an alternative fixing to insert in Euribor swaps contracts as a fallback in case the original rate ceased.
A parallel effort was aimed at bolstering Euribor by basing the benchmark on a greater number of actual transactions. In March, 48% of submissions for one-month Euribor were level three inputs, which rely on panel bank judgement and modelling of related data. This rose to 75% for three-month settings.
By contrast, €STR is constructed wholly from real transactions averaging €50 billion in daily trades. Swaps referencing €STR began trading in October 2019.
Yet many warn €STR has seen little traction beyond the standard use cases for Eonia; primarily its role as the rate for discounting future cashflows on euro instruments at central counterparties and under bilateral credit support annexes.
“We conduct a lot of floating rate euro business and Euribor is still the predominant interest rate,” says KfW’s Schmidtchen. “We have implemented €STR in our business for the cases in which we used Eonia before. Our credit support annexes are all €STR based.”
Despite Euribor’s staying power, €STR has become the norm for the euro leg of cross-currency swaps since the start of 2022, when US regulators called on dealers to stop writing new dollar Libor business and use SOFR in derivatives trades.
Rather than mix backward-looking risk-free rates with forward-looking credit sensitive rates, dealers preferred to eliminate mismatches by adopting overnight rates on both legs of the contracts.
“I can’t remember the last time someone showed a Euribor cross-currency price,” says a trader at an international dealer.
SOFR versus €STR crosses traded $131 billion notional volume in May, data from the Depository Trust & Clearing Corporation’s trade repository show. By comparison, SOFR versus Euribor crosses totalled just $1.7 billion.
“Now we’ve got a market that has pretty much gone overnight from dollar Libor versus Euribor to SOFR versus €STR,” says the benchmark transition manager. “That has other ramifications on other areas of the market.”
Striking a match
Changes in interbank cross-currency standards are keenly felt by Europe’s frequent issuers. These entities are not yet major users of €STR as their liabilities are typically pegged to Euribor.
When issuing foreign currency debt, for example in US dollars, these entities tend to pay Euribor to their dealers and receive SOFR to meet the bond payments. In broker markets, dealers must now hedge this currency exposure through €STR/SOFR swaps, meaning they pay €STR and receive SOFR. This leaves dealers holding a Euribor/€STR basis, which they must hedge on a daily basis via their interest rate swap desk. Similarly, overseas borrowers issuing in euros can generate the same churn in €STR basis markets.
“Whether it’s US corporates or euro issuers, you have this dynamic of dragging people away from six-month Euribor and into either three-month, or directly into €STR. It’s forcing some parts of the market to adopt €STR and we are seeing an uptick in volumes of interest rate swaps traded,” says the benchmark transition manager.
KfW uses cross-currency swaps to flip the majority of its US dollar funding back to Euribor – the rate underpinning the bulk of its loan book. KfW raised over $22 billion of US dollar funding in 2021, representing 26% of its annual total.
The cost of swapping from SOFR to Euribor has risen as a once sleepy Euribor/€STR basis has become more unpredictable, thanks to rates uncertainty and additional hedging activity.
“As of late, the Euribor/€STR basis has become volatile and that’s been reflected in the price,” says Olek Gajowniczek, FX swaps and cross-currency trader at Nomura. “People are finding out they’ve got risks that they hadn’t really been thinking about because it used to only move 0.1 basis points per day. Now it can move one basis point per day and that’s massively increased volatility and hedging costs in this space.”
“There’s obviously a commensurate knock-on impact when it comes to cross-currency swaps, because the broker market hedges to €STR,” he adds.
The rising cost has not gone unnoticed at KfW.
“If we purely look on the funding side, it should be more efficient for us to turn dollars into euros based on €STR. Turning it to Euribor means there are additional costs,” says Schmidtchen. “At the end of the day, we have to match the funding book with the loan books.”
In theory, adopting the interdealer standard should eliminate additional hedging charges for frequent borrowers, yet lenders could find that any benefits are quickly eroded by lower liquidity in the overnight rate.
“Currently it would be more costly to hedge the fixed rate euro exposure against €STR,” says Schmidtchen. “In most circumstances [we] would have to pay more for the interest rate swap than we gain on the funding side.”
He adds that greater adoption of €STR is likely to be focused at the shorter end of the maturity spectrum where liquidity sits. Data complied by Isda shows that 80% of €STR swaps notional traded during the first quarter of 2022, or $5.8 trillion, came in tenors of up to one year. Just 5.8%, or $421 billion, was traded in tenors beyond five years.
Schmidtchen says greater liquidity in shorter tenors of €STR would suit a lender like KfW, whose US dollar funding is also “relatively short term”.
Tradeweb reports more clients shifting from Euribor to €STR. They include bank desks trading cross-currency swaps and foreign exchange forwards that are now priced against the risk-free rate. But the numbers are small – “not enough to move the needle”, says McDiarmid.
Nomura’s Gajowniczek says the cross-currency market is unlikely to be a primary catalyst for broader adoption.
“Only if cross-currency related duration flow started to dominate the market, would liquidity perhaps shift from Euribor. But I can’t see that happening as the cross-currency market isn’t big enough,” he says.
Evidence from Eonia’s demise suggests that voluntary transition is likely to be a tough sell to the euro rates market. Tradeweb’s McDiarmid says the majority of swap trading activity remained pegged to Eonia right up until the point at which the benchmark ceased. Only then did users make the switch to €STR.
In adopting interdealer cross-currency conventions – even for pockets of activity – frequent borrowers would need to usher some of their liabilities to €STR. Yet lending markets can struggle to adopt overnight rates, where interest payments are not known in advance and where there is no credit sensitivity.
In the US, a forward-looking term SOFR published by CME has become a benchmark of choice for corporate lending activities. Plans are afoot to create a similar term benchmark for €STR.
“The big hurdle is the lack of a forward-looking term rate. You can read across to US transition, where a key unblocker has been recognising that segments of the market will need a forward-looking term rate,” says the benchmark transition manager.
Potential providers of a forward-looking term €STR have been invited to present their methodologies to the euro working group on June 17, reigniting a project that stalled after an early round of presentations in October 2019.
The European Money Markets Institute, which publishes Euribor, has teamed up with Ice Benchmark Administration to devise a term €STR, which it will pitch later this month.
But a term rate requires a liquid underlying €STR swap market. The benchmark administrator would need data from hundreds, even thousands of trades at different points of the maturity curve to construct a reliable term rate. So far, liquidity is lacking in €STR swaps, observers say.
In March, the euro working group convened a new €STR taskforce aimed at fostering use of the risk-free rate “in a diverse range of financial products”.
Eurex is working on a plan to launch the first €STR futures contracts.
“We have designed €STR contracts and are evaluating how best to serve this segment going forward. Volumes are picking up in the over-the-counter market, albeit slower than other jurisdictions, namely US and UK. Futures are seen as natural part of the product toolkit, it is more a timing consideration,” says a spokesperson.
Until activity picks up in underlying €STR swaps, authorities may struggle to establish a term €STR. But without a term €STR, lenders like KfW may be deterred from switching their loan books to the risk-free rate. The “chicken and egg” situation – as Schmidtchen describes it – looks likely to continue for now.
Editing by Alex Krohn
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