The European Central Bank (ECB) recently conducted a market consultation to assess three candidate euro overnight rates as alternatives to the current benchmark EONIA, the long-established risk-free rate (RFR) for pan-European lending. A recommended RFR may be selected as early as September.
PULSE ONLINE caught up with Yuliyan Georgiev, Fixed Income Director at STOXX, to discuss the merits of STOXX® GC Pooling EUR Deferred Funding Rate (GC Pooling Deferred) as a benchmark rate for funding costs in Europe.
Yuliyan, what are the main advantages of GC Pooling Deferred as a potential euro RFR and what role can it play in the development of Europe’s funding markets?
The majority of lending transactions are today executed in the collateralized, i.e. secured, market. That is something that authorities in the US and Switzerland have taken into account and that has led them to select secured rates as new RFRs in those markets.
GC Pooling Deferred is a simple and robust representation of general collateral, or GC, transactions in euros, captured on a liquid, centrally-cleared and anonymous market. The repo market’s characteristics make it particularly valuable during stress periods, when you need a viable and reliable RFR. Proof of that were strong repo volumes during Southern Europe’s sovereign debt crisis, even when unsecured and secured bilateral lending broke down.
As mentioned in the ECB’s consultation paper, unsecured markets are in general more affected during a crisis. Thus, you can expect more significant gaps in their rates and volumes to materialize, such as when heterogeneous Eurozone capital markets led to significant disruption in 2014. This effect is mitigated somewhat with a secured rate.
In particular, GC Pooling Deferred has a high correlation to EONIA and ESTER, the ECB’s newly-produced rate, and the smallest spread to EONIA compared to the other candidate rates. This means it would present the lowest transition cost from EONIA among the alternatives considered.
Are the candidate rates mutually exclusive?
Not necessarily. Even though optimal liquidity can be ensured by coalescing around a particular rate, we should also consider a two-benchmark scenario, which would enable market participants to choose between a secured and an unsecured rate. Unsecured and secured markets will continue to co-exist, and market participants will probably need two representative rates to choose the right one for the right purpose.
The ECB RFR working group is considering the possibility of two rates: one as an EONIA replacement and one as a fallback rate in case of exceptional or unforeseeable events.
There is not really a lot of time to transition to a new rate before 2020, when EONIA faces incompliance with upcoming regulation, is there?
There isn’t. The transition timeline is further complicated by both legal and technical factors that must be addressed, including the time needed to build term rates if they are to be derived from the new RFR. That is why I feel it will be beneficial to start the transition process as soon as possible, by using an established rate with an existing long history of data (eight years of daily pricing in the case of GC Pooling Deferred). In addition, the already available cash-settled futures on GC Pooling Deferred can facilitate the quick development of an RFR term structure.
We have observed the following descending order in the rate levels: EONIA, GC Pooling Deferred, ESTER. How can an unsecured rate like ESTER be lower than a secured one like GC Pooling Deferred?
EONIA represents the unsecured ‘lending’ side, and ESTER the unsecured ‘borrowing’ side. GC Pooling Deferred fixes in between the two unsecured rates due to the flexibility, safety and efficiency offered in the GC Pooling market, which is used as a daily liquidity management tool by treasury departments.
As all three, GC Pooling Deferred, ESTER and EONIA are cash-driven rates, they are very similar and exhibit a relatively stable spread.
How do you explain the quarter- and year-end spikes in the GC Pooling Deferred rate level?
This behavior is typical for the secured markets, and GC Pooling Deferred has reacted in a smoother manner than other secured rates. However, we cannot ignore the fact that the rate is also impacted by the relative scarcity of collateral and regulation-driven constraints on banks’ balance sheets. The wide range of ECB-eligible collateral in GC Pooling – around 14,000 instruments – mitigates that impact significantly.
I’d also remark that spikes are only very short-term, at most two days, and therefore should have only a limited impact. The daily volatility of GC Pooling Deferred over the past five years is only slightly above that of EONIA: 5.3 basis points for the former versus 3.8 basis points for the latter.
In other markets, such as the US and UK, the central bank is administering critical benchmarks. Can a private company qualify as benchmark administrator?
When the ECB released the ESTER methodology, it specified that their rate would ‘complement existing benchmark rates produced by the private sector and will serve as a backstop reference rate.1On the whole, it’s not unusual for benchmarks to be privately administered. The RFR in Switzerland, for instance, is administered by a private organization.
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1European Central Bank, ‘ESTER methodology and policies,‘ Jun. 28, 2018.