The reform within the reform
IBOR-Reform
6. November 2018

The reform within the reform

IBOR Transition: Enhancing EURIBOR and LIBOR.

While many participants focus on the interest rate benchmarks after the LIBOR and EURIBOR, the administrators are working on enhancing the existing benchmarks to be compliant with the international IOSCO principles and the EU benchmark regulation (EU BMR).

These enhanced benchmarks are known as Evolved LIBOR and Hybrid EURIBOR. The aim is to anchor the LIBOR and EURIBOR in actual market transactions and to reduce the dependency on panel banks and expert judgement. Both administrators have published the results of their methods and thoughts on updating the methodology:

 

ICE / IBA
LIBOR
ICE/IBA expected the transition to be complete by the end of Q1 2019
EMMI
EURIBOR
EMMI expects to file for authorization to the Belgian Financial Services and Markets Authority (FSMA) by Q2 2019. Subsequently, EMMI will transition panel banks from the current Euribor methodology to the hybrid methodology, with a view of finishing the process before the end of 2019

Table 1: ICE/IBA and EMMI sources

 

The main challenge to the administrators is that the underlying unsecured money market is not liquid enough to support a purely transaction based approach. Therefore, the task of updating the benchmarks becomes more difficult.

Every benchmark has two distinct properties

  • Underlying interest, i.e. what the benchmark is measuring
  • Methodology, how the measurement is being done

First, a benchmark must define the underlying interest. This is a description of the market or economic reality the benchmark is measuring. The rates benchmarks defines the underlying interest in form of a question.

Pre reform underlying interest: Updated underlying interest:
ICE / IBA
LIBOR
“At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am?” “A wholesale funding rate anchored in LIBOR panel banks’ unsecured wholesale transactions to the greatest extent possible, with a waterfall to enable a rate to be published in all market circumstances”.
EMMI
EURIBOR
“the rate at which euro interbank term deposits are being offered within the EU and EFTA countries by one prime bank to another at 11.00 a.m. Brussels time.” “Euribor is a measure of the rate at which wholesale funds in euro could be borrowed by credit institutions in the EU and EFTA countries in the unsecured money market.”

Table 2: Benchmark Statements

 

The updated statements have in common that the focus is now fully on the cost of unsecured bank liabilities provided by the wholesale market. This change increases the number of eligible transactions for the determination process.

However, it may also shift the entire benchmark lower as we have seen in case of Eonia and ESTER.

The determination method of both administrators uses a waterfall approach to extract as much information out of actual transactions as possible. The waterfall has three levels

  • Level 1: Actual Transactions corresponding to the benchmark tenors
  • Level 2: Derived rates based on other money market transaction, including interpolated data
  • Level 3: Expert judgement

The two administrators are pursuing different variations concerning the actual methodology. Examining the results, they are both trying to strike a balance between

  • Low spread compared to the existing panel based IBOR
  • Low day to day volatility of the benchmark
  • Low dependency on Level 3 (expert judgement)

Given the amount of disclosure from both administrators, it is difficult to judge how well they have done.

ICE/IBA has published actual time-series with the outcome of the test rates. They have not disclosed details about competing methods or parameters. EMMI has not disclosed the actual test rates, but is focusing more on the methodology tweaks. It is impossible to estimate the impact of the changed methodology, since only 15 of the 20 panel-banks where contributing to the testing. EMMI decided to exclude one bank and four banks were not able/willing to participate. EMMI has chosen not to disclose the banks in the test.

Are the new methods the cure to the missing volume?

Simple answer: No, not even for the large markets such as USD or EUR.

Source: EMMI

Source: ICE/IBA

 

Focusing on the most important derivatives tenors (3M and 6M) the charts and disclosures indicate the following dependency on banking panels as well as the average spread to the existing IBORs based on the new methodology:

 

Tenor Level 3 EURIBOR* Level 3 LIBOR* Basis EURIBOR
1.5 – 31.7.2018
Basis LIBOR
15.7-15.12.2017
3M 69% 79% Not disclosed,
In the range -5 bis -1 bps
Median -1,81 bps
Average -1,70 bps
(SD 0,57)
6M 83% 87% Not disclosed,
In the range -5 bis -1 bps
Median -3,54 bps
Average -3.43 bps
(SD 0,60)

Table 3: Source ICE/IBA and EMMI; test results for tenors 3M & 6M;* rounded

Both administrators are planning to change the methodology one bank at a time in order to smooth transitional effects.

Conclusion

The disclosures from ICE/IBA and EMMI clearly shows that even with the inclusion of wholesale funding it is not possible to create transaction based unsecured funding benchmarks for banks.

The market seems content with a shift of IBORs in a range up to 5 bps. Currently the consultations (ICE/IBA) do not reveal any real concerns regarding this bias. Inclusion of wholesale funding will most likely push down the level of the IBORs. However, the exact shift will also depend on the prevailing interest rate environment.

 

Christian Behm
The author
Christian Behm

Christian Behm, CFA, is with LPA since 2004. He has broad experience in advising banks and has got a distinct capital markets focus. As Partner he is responsible for LPA’s Risk & Quant Consulting Practice and he covers large consulting mandates.

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