Offshore Eonia? A weird idea for weird times

There are few things more intrinsically European than Eonia. It is the benchmark overnight rate for overnight loans in euros; the 28 banks still contributing to it are European, and most are from eurozone countries. By anyone’s standards, that is true-blue, circle-of-stars European.

So the idea of an offshore Eonia swap market, constructed for the benefit entirely of non-European banks, initially sounds weird.

It’s an idea being discussed – quietly – because the euro swaps market finds itself in a situation that is equally weird.

The backstory is that Eonia is used to discount cash-collateralised, Euribor-referencing swaps, and that it appears to be doomed after the group charged with overhauling the rate threw in the towel. There aren’t enough overnight interbank loans to make Eonia meaningful, so the reference rate will probably not satisfy the terms of the EU’s new rules on benchmarks, the European Money Markets Institute warned in February.

If they are correct, it means Eonia can no longer be used in new trades after the rules take effect from the end of next year, including the Euribor-Eonia basis swaps used by banks to hedge the risk that the two rates will diverge. In addition, with no new trades being executed, there will be no Eonia curve to use when discounting existing trades.   

A replacement risk-free-rate (RFR) is in the works, but there are three current contenders and the perceived front runner – the European Central Bank’s euro short-term rate, or Ester – will not be published until sometime next year. That doesn’t leave much time to build a liquid curve.

The euro RFR working group has already warned of potential valuation disruption and risks to market function due to the truncated timetable, introducing a new sub-group at its latest meeting to deal with issues raised by the transition. But many are still concerned there isn’t enough time to build sufficient liquidity in the new RFR by the deadline.

Traders that have not been following the issue are shocked when they learn about the implications.

“That’s crazy,” splutters one London-based rates trader who has been close to other benchmark reform discussions. “That can’t be the plan.”

He’s right, in a sense – there was no plan to leave euro swaps dealers without a key rate and hedging instruments, but that is the situation they face.

Or, to be more precise, it’s the situation they face if they are subject to the EU’s Benchmarks Regulation. And this is where the notion of offshore Eonia comes in.

In theory, the reference rate doesn’t have to die – it just can’t be used by European banks. If the benchmark still existed, other banks could potentially continue trading swaps against it among themselves, creating a curve which could be used for discounting purposes, and could even trade new Eonia-Euribor basis swaps to hedge their books.

One large non-EU bank which is looking into the issue says that while the offshore liquidity pool may be missing 90% of its current participants, it would only be used as a short-term bridge, until the market in the new euro RFR finds its feet. A second industry source confirms the idea has been floated.

A benchmarks expert at one EU bank isn’t surprised. He suggests European regulators may have “shot themselves in the foot”, creating an unlevel playing field for their banks, which would be unable to value and hedge their euro swaps in the same way as their non-EU rivals.

It remains a long shot – traders at other non-EU banks say they haven’t come across the idea, and it’s not obvious the Eonia panel banks would continue producing a rate they couldn’t use – but that’s not the point. The fact it is being discussed at all says a lot about where the market sits right now: desperate times call for desperate measures, they say, and offshore Eonia is the most desperate measure yet.