Change Ahead in the World of Lending Market Rates
Dr. Jan-Carl Plagge, Head of Applied Research
Ten years after the global financial crisis, there is not a single lending benchmark rate to have been overhauled despite efforts from those mandated with guarding markets.
Central banks and regulators, however, have acted up in recent months to reformulate established rates such as Euribor and LIBOR, vital variables of the financial ecosystem and the economy. The traditional methodology of basing rates on judgments rather than actual transactions has shown its shortfalls, particularly in times of financial stress.
So far, some inferences seem to have emerged in the overhaul process: firstly, that incumbent rates may be unfixable in their current form. Secondly, that a solution may lie in incorporating rates from secured funding markets such as repo transactions.
Euribor and LIBOR fall to manipulation, low volumes
For years, Euribor (the average rate at which European banks offer to lend to each other), and its London-quoted equivalent LIBOR, were the undisputed interbank lending benchmarks for long-term rates. They still set the price for hundreds of trillions in derivatives, loans and other credit instruments.
Two factors brought about their downfall: firstly, their declarative approach to rate setting led to manipulation and a rigging scandal. Also, volumes in unsecured interbank lending never recovered from the crisis. Banks cite quotes, but are often not lending to each other.
Euribor reform hits a snag
The European Money Markets Institute (EMMI) admitted last May that it won’t be possible to evolve Euribor into a fully transaction-based methodology. The association is now looking at implementing a hybrid methodology where actual transactions complement a quote-based system.
UK regulators in July announced that LIBOR1 will be ceased by 2021 because of insufficient transactions. The Financial Conduct Authority is working on alternative, transactions-based rates.
Overnight rates under review
In the active overnight lending market, EMMI compiles Eonia, the euro overnight index average, perceived as a near risk-free funding rate. As opposed to LIBOR and Euribor, overnight rates are based on actual transactions, arranged bilaterally between banks with no collateral or clearing process. The problem here: unsecured transactions have fallen to as low as 20% of lending volume2, with the rest taken up by collateralized deals.
Things are moving forward in this segment. The European Central Bank in September unexpectedly announced it will develop a euro unsecured overnight rate before 2020, based on transactions. Some analysts have said this move adds pressure on banks and EMMI to come up with a more credible and robust reference rate.
EMMI has reviewed Eonia since December 2015. A dwindling number of submissions has raised concern that Eonia may no longer reflect true funding costs.
The repo market has remained active
Unlike unsecured interbank lending, volumes in the secured market of repos have held up. In a repo, borrowers pledge collateral against a loan, and offer to buy it back when cancelling the debt.
Repo rates are based on high-volume transactions cleared through a central party that neutralizes any risk and are strongly correlated with the rates at which banks actually fund themselves. Hence, they are increasingly watched as indicators of short-term borrowing costs.
The repo market’s General Collateral (GC) segment is made up of very liquid, homogenous and safe collateral instruments (high-rated government bonds) that can be swiftly turned into cash. This means the GC segment is driven by demand for cash.
STOXX GC Pooling used as benchmark by the ECB
The STOXX® GC Pooling index family is STOXX’s solution in repo markets rates. The indices are based on transactions and binding quotations in the GC Pooling segment at Eurex Repo, the leading exchange for euro repos, and offer a transparent, rules-based, independent alternative to unsecured lending rates.
The repo market also has the advantage of showing constant binding quotes in longer maturities, even if volumes drop relative to the shorter-term segment.
A paper3 in 2015 showed the repo market can prove much more resilient than traditional interbank lending markets – and indeed act as a shock buffer – during episodes of turbulence.
In 2015, the ECB chose the STOXX EUR GC Pooling term indices as rates for the secured market with regard to fixed-term deposits in euros. Last June, a US government-sponsored panel selected a Treasuries repo rate to eventually replace dollar LIBOR.
All considerations for solid benchmark rates
Critics of the use of repo rates as benchmarks cite the market fragmentation that has emerged along national lines in Europe. But the rates may have an edge in their distinctive calculation methodology, something that regulators are watching with interest.
The search for a transparent reference rate that can ensure stable interbank lending is a priority for economic authorities. Secured funding benchmarks have a role to play here. The wider the scope of this search, the higher the possibility that solid rates that can price the cost of nearly risk-free lending in an accurate and reliable way, will emerge.
STOXX® GC Pooling
1 Andrew Bailey, ‘The Future of LIBOR,’ FCA, 27/07/17.
2 Data from the International Capital Market Association
3 Mancini, Ronaldo and Wrampelmeyer, ‘The Euro Interbank Repo Market,’, University of St. Gallen, Jul. 30, 2015.