The secured interbank lending market may play a role in the search for a reliable indicator of the cost of funding in Europe.
The European Central Bank (ECB) is considering the repo market as it moves to establish a risk-free rate for pan-European lending.
The Eurozone’s top monetary authority launched a market consultation on Jun. 21 to assess three candidate euro overnight rates as an alternative to the current benchmark EONIA, a key rate for the global financial system, and determine the market’s preference – as EONIA faces incompliance with upcoming European Union regulation.
The ECB said in a press release that it is putting forward ESTER, its own new rate based on reported euro deposits between financial firms, for consideration. The other two candidates stem from the market of secured euro lending transactions: the STOXX® GC Pooling EUR Deferred Funding Rate (GC Pooling Deferred), a centrally cleared, general collateral (GC) repo rate; and a combined general and specific collateral repo rate compiled by NEX Data Services.
Central banks and regulators have moved in recent months to reformulate established money-market rates such as Euribor and LIBOR. While those rates are vital variables of the financial ecosystem, their declarative approach to rate-setting led to manipulation. Moreover, they represent the unsecured interbank lending market, where volumes have plummeted since the global financial crisis.
In this context, the ECB set out in 2017 to develop a euro unsecured overnight interest rate that would complement existing benchmarks produced by the private sector.
EONIA is considered near risk-free and reflects unsecured transactions. As opposed to LIBOR and Euribor, overnight rates such as EONIA are based on actual interbank transactions, but with no collateral or clearing process. The problem here: unsecured transactions have fallen to as low as 20% of the overall lending volume. EONIA is currently under review by its administrator amid concerns about its lack of representativeness.
US and Swiss authorities have already resorted to the collateralized market to establish key risk-free rates.
Transparency sought for the bloodstream of financial markets
The search for a transparent and stable interbank lending reference rate is a priority for economic authorities. According to estimates, some 160 trillion euros are currently tied to the existing reference rates; of these, EONIA references around 34 trillion euros.1
EONIA will not be compliant with the new European Union Benchmarks Regulation that will kick in 2020 in its current form, the central bank has said. ESTER will be published by October 2019.
A rate that’s representative of markets
Turnover in the secured interbank lending market of repos, on the other hand, has held up. In a repo, borrowers pledge collateral against a loan, and offer to buy it back when cancelling the debt. The GC repo segment represents secured funding and is made up of a basket of very liquid, homogenous and safe collateral instruments, which can be swiftly turned into cash. This gives it a unique, cash-driven and near risk-free profile.
By contrast, the so-called specific security repo segment represents the cost for single security financing. It is driven by the demand for a specific, individual type of collateral and thus tends to be more heterogeneous and volatile.
Cash-driven secured rates have a role to play in the accurate depiction of European funding costs, and can complement unsecured rates. Their advantage is highlighted during periods of market stress, when banks favor secured and centrally-cleared funding. For example, volumes in this market increased significantly in 2013 and 2014 amid the European sovereign debt crisis.
GC Pooling Deferred is a simple and robust representation of the cost of pan-European one-day secured funding, with over eight years of daily historical data. It is strongly correlated to EONIA, showing the narrowest spread to the benchmark among available rates. In addition, cash-settled futures on GC Pooling Deferred are already available and can facilitate the development of a risk-free rate term structure.
Several possible outcomes of the market consultation are being considered. The solution could involve two rates, one as an EONIA replacement and one as a fallback rate for the markets in case of exceptional or unforeseeable events.2 Another option would be a two-benchmark scenario, which would enable market participants to choose between a secured and an unsecured rate.
A reliable market based on transaction data
GC Pooling Deferred tracks broad-based and reliable market data. The index is based on transactions in euros at Eurex Repo’s GC Pooling Market, the regulated marketplace for standardized GC baskets, originated by over 130 participants from 17 European countries. The market represents a substitute to central bank liquidity and has the advantage of a real-time collateral management system with re-use of collateral, and refinancing within the framework of ECB open market operations.
A reliable and experienced index provider
STOXX is a leading global index provider with a European heritage. It calculates more than 12,000 indices that are compliant with the International Organization of Securities Commissions’ (IOSCO) Principles for Financial Benchmarks and expects to be fully compliant with the new EU Benchmarks Regulation.
The ECB’s market consultation will last until Jul. 13 and a recommended euro risk-free rate may be selected as early as September. The rate will serve as a basis to develop a methodology for different maturities and terms in 2019.
1,2 Börsen-Zeitung, ‘IM INTERVIEW: CORNELIA HOLTHAUSEN, GENERALDIREKTION MARKET OPERATIONS,’ Jun. 6, 2018