interest rate benchmarks in need of a fix - intere… · 2/7/2019 · cardano interest rate...

Interest Rate Benchmarks in Need of a Fix Meeting CFA Society VBA NetherlandsFebruary 7, 2019

© 2019 Deloitte

Contents

1Interest Rate Benchmarks in Need of a Fix

I Regulation and timelines

Important requirements impacting the IBOR transition

II Market updates and recent developments

Euribor transition

EONIA to ESTER transition

Transition scenarios

Loan and swap scenario examples

III IBOR transition programme

Programme outline

© 2019 Deloitte

I. Regulation and timelinesImportant requirements impacting the IBOR transition


© 2019 Deloitte

After the publication of Benchmark principles is 2013, regulation and technical advice for the European Union followed in 2016

Benchmark regulation overview


IOSCO – Principles for financial Benchmarks (2013)

• Global standards for regulatory requirements for benchmarks

• Principles related to: governance, quality of the benchmark, quality of the methodology and accountability

European Regulation (EU-2016/1011) – Benchmark regulation (2016)

• Regulatory framework for benchmarks at [EU] Union level, entered into application on January 1, 2018

ESMA – Technical advice under the Benchmarks Regulation (2017)

The Commission requested technical advice from ESMA on five areas: i. definitions;ii. measurement of the reference value

of benchmarks;iii. criteria for the identification of

critical benchmarks;iv. endorsement of a benchmark

provided in a third country; andv. transitional provisions.

FSB – Reforming major interest rate benchmarks (2014)

• Proposals, plans and timelines for the reform and strengthening of existing benchmarks and for additional work on the development and introduction of alternative benchmarks

© 2019 Deloitte

Important legal definitions used within the EU benchmark regulation

Definitions


Any figure, that is published or made available to the public and regularly determined

Any index used to determine the amount payable under a financial instrument or financial contract, or the value of a financial instrument, or used to measure the performance of an investment fund

Index Benchmark

Benchmark determined on the basis of the rate at which banks may lend or borrowfrom other banks or agents other than banks, in the money market

Interest rate benchmark

Benchmarks is used as a reference for financial instruments or financial contracts or for measuring performance of investment funds, having a value of at least EUR 500 billion on the basis of all the range of maturities of tenors of that benchmark

Critical benchmarks

© 2019 Deloitte

Decreasing number of panel banks, increasing concentration and measurement of interbank risks

Increasing deficiencies of the current Euribor interest rates


Source: European Money Markets Institute (EMMI)

43

40

33 33 33

31

28

2019

0

10

20

30

40

50

< 2012 2012 2013 2014 2015 2016 2017 2018 2019

Number of Euribor panel banks

© 2019 Deloitte

2022 2023 2024

Regulation (EU) 2016/1011 went into force on 1-1-2018, with a transitional period ending 1-1-2020. EONIA will cease 1-1-2020, LIBOR will end late 2021

Regulatory timelines


Transition considerations

• Extremely short timelines. ECB has indicated that ESTER will go live in Q3 2019, leaving only one quarter for creating a liquid market and the transition before being compliant with the European Benchmark Regulation (BMR) on January 1, 2020

• Unfair level playing field. For UK and US banks the LIBOR transition deadline is end of 2021, two years after the (current) BMR deadline

• Extension period. Private sector working group of the ECB recommends to keep EONIA until the end of 2021

• Lack of term structure. ESTER, the alternative RFR for EONIA, is an overnight rate and does not provide a term structure

• Potential mismatch between funding and assets. Most complexity is expected during the transition period.

2016 2017 2018 2019 2020 2021

“Existing” benchmarks

30 June 2016Regulation entered into force

Legislative

process

1 January 2018Regulation applies

1 January 2020Transitional arrangements end

EU BMR compliant

“New” EU benchmarks

“Existing” EU benchmarks: Benchmarks created pre 1 January 2018“New” benchmarks: Benchmarks created post 1 January 2018

29 March 2019Brexit

End of 2021 onwardsFCA will not compel panel banks to contribute to LIBOR

April 2018• SOFR started publication by

NY Fed• Reformed SONIA published

by BoE

Sep 2017 onwards• Estimated finalised RTS published• Expected FCA’s CP on applications

Q3 2019Alternative RFR for EONIA and Euribor expected to begin publication

Expected period for applications

July 2017Andrew Bailey announces the FCA will not compel banks to contribute to LIBOR from end of 2021

1 April 2017• ESMA submits

final draft RTS

Regulation andtimelines

Extension period

2020-2021Private sector working group of the ECB recommends to keep EONIA until the end of 2021

Proposal to extend use of critical benchmarks

© 2019 Deloitte

Benchmark regulation will heavily impact benchmark contributors and users

Regulatory requirements


Effective from 1 January 2018, the EU Benchmark Regulation will impose new requirements for firms that are an administrator for, a contributor to, or a user of a wide range of interest rate, currency, securities and / or commodity indices and / or benchmarks.

The regulation aims to reduce the risk of manipulation of benchmarks by addressing conflicts of interest, governance controls and the use of discretion in the benchmark-setting process. Additionally, benchmarks will now require authorisation and registration by a National Competent Authority (NCA) to protect users and ensuring the integrity and reliability of published benchmarks.

Key implications

• EONIA, Euribor and LIBOR have been recognised as Critical Benchmarks by ESMA. ICE Benchmark Administration Ltd (the administrator of LIBOR) has been authorised as a EU Benchmark Administrator by the FCA in April 2018. EMMI seeks authorisation per January 1st, 2020.

• No financial instruments, financial contracts or measurements of the performance of an investment fund will be able to add a reference to the existing EU benchmark after 1 January 2020 unless administrator is authorised or registered.

• EONIA, Euribor and LIBOR do not currently comply with BMR. EMMI is looking to reform Euribor to be compliant, but will not reform EONIA.

• In September 2018, the industry-led working group announced ESTER as the RFR for the Euro area. The industry-led working group recommends a recalibration approach for the market transition from EONIA to ESTER. Under the recalibration approach, EONIA no longer relies on a banking panel as in the current methodology, but is calculated as a fixed spread over ESTER.

• Regulators are supportive of the efforts to reform Euribor to use a hybrid methodology. Analysis shows however, that volumes may still be insufficient.

• Article 2.2a allows Benchmarks administered by Central Banks such as ESTER, SONIA, TONA and SOFR (by the ECB, Bank of England, Bank of Japan and New York Federal Reserve respectively) to be exempt from the Regulation.

• Responsibility is now on users of EU benchmarks to check their administrator is authorised/registered under ESMA register.

Regulation andtimelines

© 2019 Deloitte

II. Market updates and recent developmentsEONIA, Euribor, fallbacks and transition


© 2019 Deloitte

II.1 Euribor transition


Cardano 10Interest Rate Benchmarks in Need of a Fix

Use of EURIBOR more diverse than EONIA

• EURIBOR heavily used in derivatives but also in loan market

• EONIA less used as reference but heavily used as discounting rate

in derivatives


What are we talking about?

EURIBOR RELATED CONTRACTS

World GDP

EU GDP

Σ PFs NL


What are we talking about?

All PF in NL

EURIBOR

contracts

PF KLM

Vliegend


Retail mortgages linked to Euribor in periphery


EURIBOR reform

• We need a new EURIBOR Hybrid EURIBOR

• Fallback rate for EURIBOR ESTER

• But, a fallback rate needs a term structure (the subject of

recent ECB consultation):

- Forward looking (defines rate for upcoming term)

- Backward looking (defines rate for past term)

Possibly different methodologies for different asset classes

• Good news: EURIBOR and EONIA are critical benchmarks


EURIBOR reform: Hybrid EURIBOR

3- level Waterfall structure:

1. Transactions T-1

2. More transactions

3. Expert judgement

I think we need a fallback….

Waterfall


Term structure in ESTER: forward looking

Forward looking

Futures

based

OIS transactions

based

OIS tradeable

quote based

OIS transactions &

quote based

OTC Overnight

Index Swap based

Sufficient transactions?

How to determine fixing?

Manipulation?

Sufficient transactions?

Model (and assumptions)

based

No history


Sufficient transactions in OIS? Clearly not.

Preference ECB working group: OIS Quote Based method


Term structure in ESTER: backward looking

Backward looking

Fixing in advance Fixing in arrears

Compounding Arithmetic mean Compounding Arithmetic mean

1 2

Fixing in advance1 rate is known before the accrual period starts:

𝑡0 𝑡1 𝑡2Rate determination Rate application

Settlement

Fixing in arrears2

observation period is the same as the accrual period:

𝑡0 𝑡1Rate determination = Rate application

Settlement

Derivatives markets prefer: Fixing in arrears, compounding

Backward looking

Fixing in arrears

Compounding


EURIBOR reform scenarios

EURIBOR

reform

succes

Swaps started pre 1 Jan 2020 New swaps after 1 Jan 2020

New EURIBOR

same as existing

EURIBOR

No material impact; smooth transition

New EURIBOR

different from existing

EURIBOR

Transition required: existing

swaps refer to new EURIBOR

or alternative RFR

New swaps to refer to

new EURIBOR

or alternative RFR

EURIBOR

reform

fails

Existing non-BMR

compliant EURIBOR

continue quoted

No transition required:

Existing swaps refer to old

EURIBOR (force majeure) New swaps to refer

Alternative RFR

Existing EURIBOR

ceases to be

quoted (2yrs notice)

Transition required:

Existing swaps refer to new

RFR (after 2yrs at latest)

© 2019 Deloitte

II.2 EONIA to ESTER transition



Transition from EONIA to ESTER

Design transition path from EONIA to ESTER

- Parallel run

- Contractual alternative

- Pure succession rate big bang EONIA to ESTER

- Recalibration: EONIA = ESTER + Spread

Recommendations of ECB working group (December 2018)

- EONIA = ESTER + Spread

Spread to be calculated: 12M period, 15% trimmed mean

- Transition period until end of 2021

- ESTER to replace EONIA in Credit Support Annex

So, before ultimo 2021 all references to EONIA must be gone

EONIA and ESTER side-by-side


ESTER Spread

• Borrowing (ESTER) versus Lending rate (EONIA)

• ESTER based on wider range of transactions

• ESTER Spread c. 9bps


Transition from EONIA to ESTER

How to create a liquid derivatives market based on ESTER

No counterparty risk in the curve cleared ESTER swaps

Market requires Supply and Demand

- Supply = Banks

Difficulties: FRTB (2021): use of internal models require data

based on history. ESTER has no history more capital required

to quote ESTER product

- Demand = Hedgers

Trigger for pension funds = DNB discount curve. What will DNB

decide on RTS?


Transition from EURIBOR TO ESTER

Current contract: 30Y Fixed versus 6M EURIBOR

discounted at EONIA

Becomes: 30Y Fixed versus [EONIA + 30Y OIS Spread]

discounted at EONIA

Becomes: 30Y Fixed versus [(ESTER + 9) + 30Y OIS Spread]

discounted at (ESTER + 9)

New contracts: 30Y Fixed versus ESTER

discounted at ESTER


Market standard after reform: ESTER discounted swaps

Initial Swap details: 30Y Fixed versus Floating

State Fixed rate Floating Rate CSA par 11

Interest Rate VM

Cash payment

Initial 1.50% 6M EURIBOR EONIA 0

After reform 1 1.50% ESTER + 9bp + OIS Spread ESTER + 9 0

After reform 2 1.51%* ESTER + 9bp + OIS Spread ESTER 0

After reform 3 1.50% ESTER + 9bp + OIS Spread ESTER PV(1bp)*

Alternative 1 not preferred because market standard will move to ESTER

discounted swaps. Two options remain:

- Adjust fixed rate in the swap, or

- Pay out difference in present value

* For illustration purposes only


Fixing the OIS Spread

• OIS Spread might be (ISDA consultation December 2018):

– Spot spread at time of conversion

– Historical average

– Forward approach

• OIS Spread is volatile due to speculation

• Lessons from UK perspective:

Market reaction following Andrew Bailey speech July 2017

“I and my colleagues have therefore spoken to all the current panel banks about

agreeing voluntarily to sustain LIBOR for a four to five year period, i.e. until end-

2021.”

“Our intention is that, at the end of this period, it would no longer be necessary for

the FCA to persuade, or compel, banks to submit to LIBOR.”

“…we do not think markets can rely on LIBOR continuing to be available indefinitely.”

Outcome ISDA consultation


Transition plan: lessons from the UK

LIBOR - SONIA spread (30y, 3m vs Sonia)

Source: Bloomberg

Andrew Bailey “future of

Libor speech”

Outcome ISDA

consultation


Transition plan

EURIBOR – EONIA spread (30y, 3m vs EONIA)

Source: Bloomberg


Transition plan

SONIA spread development

EONIA spread curve 4 February 19

EONIA spread curve Dec19


Managing the OIS Spread (“X”)

• Mitigate exposure to X by simultaneously resetting ITM swaps

Reset:

• Receive (positive) MtM

• Enter into OIS swap: receive EURIBOR, pay ESTER + X

• If X decreases after fixing it in a new swap:

– The new ÒIS swap creates negative value;

– However, the received MtM would have been lower

WE NEED A LIQUID ESTER MARKET!


Impact on solvency? PensioenPro 31 Jan 2019:

‘Uit de eerste berekeningen blijkt dat de hybride euribor 1 tot 5 basispunten lager ligt dan de huidige euribor. Hiermee kan de rts van DNB ook lager komen te liggen, waardoor de verplichtingen van pensioenfondsen toenemen.’

Als DNB besluit de hybride euribor over te nemen, zorgt dit er volgens NN IP voor dat de dekkingsgraad van een gemiddeld pensioenfonds (met 50% renteafdekking) 0,5%-punt daalt.

‘Ester ligt 20 basispunten lager dan de huidige zesmaands euribor. Als DNB ester zou overnemen in de rts, zou dit een daling van de dekkingsgraad betekenen van liefst 2%-punt.

© 2019 Deloitte

II.3 Transition scenarios


© 2019 Deloitte

not approved

Three scenarios given the uncertainty around the approval and adoption of the hybrid Euribor methodology

Hybrid methodology for Euribor


Hybrid Euribor methodology approved

by the Financial Services and Markets Authority (FSMA) as competent authority expected for Q2 2019

approved

Scenario 1: Hybrid Euribor (remains) widely adopted by market participants

• Possibly no adjustments to financial contracts referencing Euribor, but exact legal implications unclear.

• Term structure on ESTER might serve as fallback only

Scenario 2: Hybrid Euribor gains limited or no acceptance by market participants

• ESTER becomes the new benchmark including a term structure based on ESTER

Scenario 3: Both Euribor and EONIA will disappear

• ESTER becomes the new benchmark including a term structure based on ESTER

1

2

3

Step 1 - Approval Step 2 - Adoption

approved

© 2019 Deloitte

Mainly forward looking alternatives that are often dependent on the availability of sufficient liquidity and volumes

ECB working group term structure alternatives to RFR


• OIS transaction based methodology

• Fixing in advance

• Futures based methodology

• OIS quote based methodology

Term structure alternatives

Possible hybrid method

• Fixing in arrears

IBOR tenor (e.g. 3M)

3M * 1D (tenor) RFR realised


3M OIS transactions

3M OIS quotes

3M futures

© 2019 Deloitte

Most ISDA definitions and market protocol alternatives are not present value neutral or increase additional complexity

ISDA term structure and credit spread adjustments to RFR


IBOR tenor (e.g. 3M)


• Compounded setting in arears rate

• Compounded setting in advance rate

• Spot overnight rate

• Convexity-adjusted overnight rate


• Forward approach

• Historical mean / median approach

• Spot spread approach

Full swap curve credit spread

Spot credit spread

Historical credit spreads per tenor

Term structure alternatives

Credit spread alternatives

1D RFR realised

1D RFR realised + convexity adjustment

Preferred by 90%of respondents

due to compatibility with OIS swap market and reflection of

daily interest rate movements during the

relevant period

Preferred by 67%of respondents

due to simplicity and resistance to

manipulation. Drawback is

potential value transfer in case

fallbacks are triggered

© 2019 Deloitte

Interest rate landscape

Swap scenario


Loan

Swap

Coupon / forward curve


Discount curve

• Assumptions,a. Interbank collateral is assumed to be similar to CSA

collateral (hence bootstrapping curve is similar to collateral implied discount curve)

© 2019 Deloitte

Current situation

Swap scenario #0 – Legacy contracts




Discount curve

Hybrid 6M Euribor

ESTER

6M Euribor

EONIA

(Not BMR compliant)

6M Euribor

(Not BMR compliant)

Hybrid 6M Euribor

ESTER + spread

(ISDA Fallback)

ESTER + term structure

(ISDA Fallback)


(Forward looking)


(ISDA Fallback)


(Forward looking)

Loan

Swap

• Coupon of both loan and interest rate swap match, based on 6M Euribor • Discounting based on EONIA curve

(Not BMR compliant)

ESTER + fixed spread(Bilateral spread)

© 2019 Deloitte

Paradise, there is a liquid ESTER and BMR compliant Hybrid Euribor for new contracts, as of 31 December 2019

Swap scenario #1 – New contracts




Discount curve

Hybrid 6M Euribor

ESTER

Hybrid 6M Euribor

ESTER + spread

(ISDA Fallback)


(ISDA Fallback)


(Forward looking)


(ISDA Fallback)


(Forward looking)

Loan

Swap

• Coupon of both loan and interest rate swap match, based on the revised hybrid 6M Euribor• Discounting based on ESTER curve

6M Euribor

EONIA

(Not BMR compliant)

6M Euribor

(Not BMR compliant)

(Not BMR compliant)


© 2019 Deloitte

Single curve discounting, hybrid Euribor gains limited or no acceptance by market participants

Swap scenario #2 – New contracts




Discount curve

Hybrid 6M Euribor

Hybrid 6M Euribor

ESTER + spread

(ISDA Fallback)


(ISDA Fallback)


(Forward looking)


(ISDA Fallback)


(Forward looking)

Loan

Swap

• Coupon of both loan and interest rate swap match, based on a forward looking term structure for ESTER• Discounting based on ESTER curve

6M Euribor

EONIA

(Not BMR compliant)

6M Euribor

(Not BMR compliant)

(Not BMR compliant)

ESTERESTER + fixed

spread(Bilateral spread)

© 2019 Deloitte

Hybrid Euribor gains limited or no acceptance by market participants, so existing contracts also need to move away from Euribor to ESTER. Fixed spread on ESTER discounting to prevent direct value transfer





Discount curve

Hybrid 6M Euribor

Hybrid 6M Euribor

ESTER + spread

(ISDA Fallback)


(ISDA Fallback)


(Forward looking)


(ISDA Fallback)


(Forward looking)

Loan

Swap

• Coupon of both loan and interest rate swap match, based on a forward looking term structure for ESTER• Discounting based on ESTER curve, plus a bilateral agreed spread to prevent value transfer

6M Euribor

EONIA

(Not BMR compliant)

6M Euribor

(Not BMR compliant)

(Not BMR compliant)

ESTERESTER + fixed

spread(Bilateral spread)

© 2019 Deloitte

No voluntary transition or agreement reached before ISDA fallback trigger is hit





Discount curve

Hybrid 6M Euribor

Hybrid 6M Euribor

ESTER + spread

(ISDA Fallback)


(ISDA Fallback)


(ISDA Fallback)


(Forward looking)

Loan

Swap

• Coupon of both loan and legacy swap do not necessarily match, as both have different fallbacks, creating a basis risk between the loan swap

• Discounting based on ESTER curve as fallback, plus ISDA determined spread to prevent value transfer

6M Euribor

EONIA

(Not BMR compliant)

6M Euribor

(Not BMR compliant)

(Not BMR compliant)

ESTER


(Forward looking)


© 2019 Deloitte

Key priorities and challenges for the IBOR transition

Transition impact


Achieve senior level understanding, support and sponsorship

Shape and mobilise their delivery programme

Complete the impact analysis

Stop the problem getting worse

Engage externally, monitor industry developments and the response of clients and competitors

• Convincing stakeholders of the scale and complexity of IBOR reform, and the need to understand the impacts now

• Engaging the right people across business divisions and geographies• Defining the role of the central / core programme team – ‘thick’ vs ‘thin’

• Establishing the scenarios and assumptions• Defining the scope, methodology, tooling and technology• Gathering and analysing the data needed to complete the assessment• Updating the impact analysis periodically

• Updating fallback provisions for new trades / contracts• Agreeing the timing of switching to products linked to Alternative Risk

Free Rates (ARFR)

• Lack of buy-side intent to move away from IBOR• Educating and managing customers• Understanding how the market is responding to conduct and competition

issues

IBOR transitionprogram outline

© 2019 Deloitte

Contact information


Sjoerd Kampen

Senior Manager

+31 (0)6 83 555 111

[email protected]

Bram de Rooij

Senior Consultant

+31 (0)6 53 846 931

[email protected]

Max Verheijen

Director Financial Markets

+31 10 2815 994 [email protected]

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interest rate benchmarks in need of a fix - intere… · 2/7/2019 · cardano interest rate...

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