How €STR is the start for a new era of euro interest rate benchmarks

The introduction of a new reference rate in trading / treasury systems and processes is not something new. Institutions frequently introduce new rates and curves using the well-established new product approval (NPA) process.

However, institutions have faced challenges with €STR adoption due to the delay in the reference rate’s publication. The current EONIA is published on the same day around 19:00 and, therefore, before the systems finish for the day. In contrast, both the new €STR and the amended EONIA will be published on the following business day, by 09:00 at the latest. Due to this delay, trading/treasury systems do not have the EONIA rate available for end-of-day valuation and P&L reporting.

Institutions have had to amend their trading / treasury and accounting systems to reflect this change in publication time, which has a particular impact on end-of-month, end-of-quarter and end-of-year valuations.

In order to address the different impacts across multiple systems and departments, almost all market participants have established cross-functional working groups that frequently discuss and define necessary changes or projects. Most institutions have performed an impact assessment across all departments to identify affected processes, systems and legal documentation – a time-consuming undertaking.

Furthermore, many market participants created dedicated run books to cover the necessary changes throughout the period when the change of publication time happened (from 30 September 2019 to 2 October 2019).

Despite the race to comply with the 2 October deadline, institutions also implemented technical steps to trade new derivatives based upon €STR and to trade and issue new securities with a compounded rate using €STR. Large agencies and supranationals have already started outreach activities to identify client demand for new €STR-based securities and prepared the necessary documentation for issuing floating rate notes with a compounded €STR coupon. As with all overnight indexed swap (OIS) compounded bonds, the late determination of the final cashflow and, therefore, time constraints in relation to interest, payments remain a major concern.

More and more market participants across Europe will start to issue and trade securities based upon the new €STR, use €STR futures and use new €STR overnight index swaps as hedging instruments. Those activities will initially only be undertaken to test implementation work and gain confidence in the products. But depending on the general market readiness and demand, trading activity will soon increase. Such developments have also been seen in the US market with the introduction of the secured overnight funding rate (SOFR), as well as in the UK with the sterling overnight index average (SONIA).

Meanwhile, the two large central counterparties – LCH SwapClear and EUREX OTC Clear – recently announced the extension of their product scope. Both counterparties will allow €STR-OIS and EURIBOR-€STR basis swaps for clearing. LCH SwapClear started such clearing on 21 October 2019, whereas EUREX OTC Clear scheduled the first cleared trades for 18 November 2019. Initially, those products will use €STR-based forwards to project future cashflows, but will be discounted using the traditional EONIA-based method.

In Q2 2020, the existing central counterparty clearing (CCP) valuation using the current EONIA curve for discounting will shift to the new €STR curve. LCH SwapClear is currently planning to implement this change in the valuation methodology on 22 June 2020. During this transition, the valuation differences resulting from a change in the discount curve will be compensated for by cash payments. Additionally, the interest on collateral (Price Alignment Interest / Price Alignment Amount) will be amended to €STR as well.

Starting from Q3 2020, a similar exercise must be undertaken by market participants to amend the existing uncleared OTC derivative valuation and collateral remuneration. Whereas the change for a given CCP will take place at a certain date using a transparent method, the changes to bilateral portfolios will range over a longer period and the methodology for calculating the cash payments will depend upon bilateral negotiations. The effort needed by market participants can be compared to the previous effort to price and remove collateral agreements with a floor for the collateral remuneration.

Currently, the market expects the amendment of EONIA-based coupons in 2021 – but no definite timeline has yet been published. The final timing will heavily depend on market liquidity in the new €STR-based instruments and how quick liquidity dries up in EONIA.

Since €STR is now live, all market participants need to plan for the actual transition of outstanding and potentially new EONIA contracts and transactions. The following actions should be taken into consideration:

• Take a business decision on whether to continue to use EONIA as an interest rate benchmark in the next two years
• For any new EONIA transaction, make sure that appropriate fallbacks are included in the legal documentation – based upon the recommendations of the ECB WG and complying with the BMR
• Inventorize EONIA-linked portfolios to plan the transition and monitor any new transactions closely
• Based upon your institution’s EONIA exposure within different product classes, develop a transition strategy which takes into consideration not only product specifics, the way products are traded and under which legal documentation, but also the classification of counterparties
• Develop a communication plan and start educating end clients in order to take them with you on the transition journey and avoid any conduct issues
• Prepare your trading / treasury systems to be able to handle the switch in discounting curves and underlying interest rate benchmark, and understand P&L impacts from both risk and accounting perspectives
• Watch market liquidity and industry working groups closely in order to identify the right time to start trading out of existing positions or to approach counterparties to discuss potential transition, including value transfers
• Expect that regulators will watch progress closely and prepare for new quantitative and qualitative assessments on your progress
• Prepare your organization to be able to work on different transition paths in 2020 and 2021, keeping in mind that London Interbank Offered Rates (LIBORs) will also cease by the same date as EONIA.
   

It’s now up to all market participants to make this transition happen in a smooth way.