EACT Summit 2019: Interest Rates Benchmarks Replacement

by Alain Chaigneau, AFTE

Workshop Leaders

  • Holger Neuhaus – European Central Bank

  • Neil Wadey – BAT


New interest rate benchmarks: a work in progress
Due to incidents in manipulation and declining volumes in the interbank market, a global reform of benchmarks has been launched. The search for more robust reference rates is a work in progress: the Financial Stability Board (FSB) recommended use of alternative risk-free rates (RFRs). And, in the Eurozone, the EU Benchmarks Regulation stipulates that non-compliant risk-free rates cannot be used in new contracts, initially as of 1 January 2020, a deadline that most likely will be postponed. So, the European Central Bank (ECB) must produce an overnight unsecured rate by October 2019.

 
The central bank selected the Euro Short-Term Rate (originally called ESTER recently rebranded to €STR) to be the new RFR and replace the Euro Overnight Index Average (EONIA). In order to avoid potential risks of value transfers, a smooth transition towards the new overnight rate will take place until December 2021, thanks to a working group for which ECB provides the secretariat. This working group recommended the use of an evolved EONIA methodology; EONIA being equal to €STR plus a spread until December 2021. 


The working group logically recommended to replace EONIA with €STR as a reference for all financial products and contracts, with the new overnight rate becoming the standard benchmark after the transition period. This working group has many issues to address in 2019 including the adaption of systems and infrastructure to the new euro-risk free rate and the set-up of ESTER derivatives markets.


Even if the transition period is extended, corporate treasurers also have to do their homework: adapt internal systems that depend on the rate, prepare legal action plans for existing and new contracts and update risk management models. Corporate treasurers ought to be involved in the process, by replying to public consultations or participating in market outreaches, to ensure acceptance of this reform.


These interest rate benchmark replacements are not just a eurozone topic, it’s a global change. In the UK, for instance, there has been a sterling working group structure since 2015. Its main objective is to catalyse a broad-based transition to a new overnight rate –Sterling Overnight Index Average (SONIA) – instead of using LIBOR-style reference rates.


For corporate treasurers, the task is huge and needs to be addressed as soon as possible. The action plan could begin with a review of the exposure in all currencies to this benchmark issue and a close examination of legacy contracts. So, many areas require a complete internal review, from cash management (interest on cash pools), to intercompany loans (transfer pricing), legal documentation (renegotiation of contracts), and external contracts (loans, bonds etc). In their action plan, corporate treasurers should also look at commercial contracts, hedge accounting, and the readiness of the treasury management system. 

Key takeaways

  • The EU Benchmarks regulation explained that non-compliant risk-free rates cannot be used in new contracts, initially as of 1 January 2020, a deadline which most likely will be postponed.

  • Euro short term rate (€STR) will be the new RFR and replace EONIA.

  • The working group logically recommended to replace EONIA with €STR as a reference for all financial products and contracts.

  • The working group has a lot of issues to address in 2019: adapt systems and infrastructure to the new euro-risk free rate, set-up €STR derivatives markets, etc.

  • Corporate treasurers must do a complete internal review, from cash management (interest on cash pools), to intercompany loans (transfer pricing), legal documentation (renegotiation of contracts), and external contracts (loans, bonds, etc.).