The ECB itself has signaled in a recent report that the situation with benchmarks has raised its concerns regarding the effects on financial stability. Meanwhile, the clock is ticking. Let us remind, that after the manipulation of the LIBOR rate and other market rates (as well as fuel price or currency indices) which were revealed after the crisis, the regulators decided to reform the indices used in the world in order to ensure that they are transparent and reflect actual transactions.
after the LIBOR manipulation trials that took place on both sides of the Atlantic, and at the beginning of April 2018, a new trial began before the Crown Court in Southwark, where several Barclays and Deutsche Bank traders were accused by Britain’s Serious Fraud Office of rigging the EURIBOR rate, i.e. the benchmark of the interbank market for the EUR, in 2005-2009. This is the first trial concerning the manipulation of this index.
Achim Kraemer, the former head of the money markets and derivatives of Deutsche Bank in Frankfurt, who was interrogated at the beginning of June 2018, testified before the court that he had been aware that traders had asked the panelists to quote rates that would be beneficial for the valuation of their trading portfolios. He added that he saw nothing wrong with that.
After the manipulation was disclosed in 2013, the International Organization of Securities Commissions (IOSCO) announced the assumptions of the reform of the indices. These assumptions guided the European Union’s Benchmark Market Regulation (BMR), which introduces the two key principles:
- the benchmark should be calculated on the basis of actual transactions carried out on a given market;
- in contracts concluded with customers a financial institution may only use benchmarks consistent with the BMR.
The regulation has been in force since the beginning of 2018, and a transitional period has been provided until the end of the year for the adaptation of the currently used benchmarks to its requirements or for the introduction of new ones. At the same time, the Market Abuse Regulation has been in force since mid-2017. It introduces rules that are supposed to prevent, among other things, market manipulations and that provide for very high penalties.
Discovering new benchmarks
The Benchmark Market Regulation came at a really bad moment. The period of negative interest rates has continued for several years in the euro area, and at the same time, the European Central Bank still has not ended the unlimited provision of liquidity to the banking sector through various quantitative easing operations.
What are the consequences of this situation for the unsecured deposit market? According to the data from the TARGET2 system, overnight quotations fall somewhere between the ECB’s main interest rate (which has amounted to zero since March 16th, 2016) and the rate on the deposit facility (amounting to minus 0.40 per cent) — reports the ECB. Along with the increase in excess liquidity since the start of the asset purchase program (APP), these rates are moving towards the value of the rate on the deposit facility.
When it comes to longer maturities, the situation is much worse, although in the overnight market the number of participants is also steadily declining. Out of the 390 banks that had access to Longer-Term Refinancing Operations (LTRO) in 2014, just over 200 were left in the previous year. In September 2017, the average daily trading volumes amounted to approx. EUR9bn, which constitutes only 34 per cent of the average daily volumes recorded at the beginning of 2014. The ECB concludes that since the financial crisis, a combination of new regulations, excess liquidity and risk aversion have resulted in a decrease in trade volumes.
An event of crucial importance for the interbank market, was the statement made by Britain’s Financial Conduct Authority (FCA), which oversees LIBOR. It announced in mid-2017 that LIBOR may disappear by the end of 2021, because there is not enough data to calculate this benchmark in a credible way. The position taken by the FCA has led to an acceleration of the work on new benchmarks.
And so already on February 1st, 2017, the Bank of England introduced a new rate for the GBP, known as the Sterling Overnight Index Average (SONIA), which could be an alternative to LIBOR once that rate is no longer published. SONIA is the rate for unsecured overnight transactions, and the problem that remains to be solved is how to build a yield curve for longer maturities based on the overnight rate.
In 2017, the American Alternative References Rates Committee (ARRC) chose the the repo rate in transactions secured with the US Treasury bonds as the new reference rate for the dollar. The Swiss central bank, SNB, announced that the rate of overnight secured transactions (Swiss Average Rate Overnight, SARON) will be the alternative reference rate for the LIBOR rate in relation to the CHF.
At the beginning of May, the Governing Council of the ECB decided to develop a new benchmark — the unsecured overnight interest rate ESTER (Euro Short-Term Rate) — before 2020. It is supposed to complement the existing reference rates developed by banks. The benchmark is to be developed on the basis of datasets from the euro zone’s money market statistical reporting (MMSR) system.
The ECB urges banks to hurry up
Despite the existing external circumstances, such as the regulatory conditions or the difficult process of rebuilding trust in the banking sector in Europe, banks have done too little to create a good alternative to the currently calculated benchmarks — believes Cornelia Holthausen, the Deputy Director General in the Directorate General for Market Operations of the European Central Bank.
“They [banks] are the largest users of these benchmarks, and, additionally, they were also responsible for the rate rigging. We are dealing with freeloaders,” she said in an interview with the Dutch financial newspaper “Het Financieele Dagblad” in April 2018.
The key market rates in the Eurozone, that is, EURIBOR and EONIA, are still set in the same way as before, despite the disclosed cases of rigging and the new European regulations. Their reform is progressing very slowly and subsequent institutions are signaling that it will probably end in failure. The European Money Market Institute (EMMI), which is the administrator of the EURIBOR and EONIA rates, warned in February that if the methodology used to determine and calculate the EONIA rate is not changed, then it would not be able to guarantee its compliance with the requirements of the BMR. Previously, the EMMI tried to expand the panel of banks submitting their quotations. That attempt did not succeed, however.
In the May’s Financial Stability Review the ECB assessed that the possible discontinued publication of the EONIA rate raises concerns regarding the consequences for financial stability. “The likely discontinuation of EONIA raises financial stability concerns, given the transition complexities and short time frame,” wrote the ECB. It pointed out that the deadline of January 1st, 2020, by which the old benchmarks are to be reformed or replaced with new ones, is very short.
“In accordance with EU regulations, banks will not be able to enter into new contracts for EONIA starting from 2020. This means that there really needs to be an alternative in this area (…) If the new standards ultimately enter into force, all these contracts will have to be adapted,” said Cornelia Holthausen.
Shortly after EMMI’s decision, the ECB, together with the Financial Services and Markets Authority (FSMA), the European Securities and Markets Authority (ESMA) and the European Commission appointed a working group on EUR risk-free rates (RFR). It is supposed to identify the causes of the problems with benchmarks and suggest alternatives to current benchmarks, as well as the possibility of a smooth transition to new rates and guaranteeing the continuity of contracts — in accordance with the requirements of the BMR. The group consists of the representatives of 21 major financial institutions of the Eurozone.
One of the conclusions of the meeting was that it was necessary to strive for a quick development of the derivatives market based on the rate which will replace EONIA. Most of the banks admitted that they would be unprepared in the event EONIA and EURIBOR do not receive a license. According to ECB and ESMA data, the value of instruments linked to the EURIBOR rate is EUR109bn, and the value of instruments tied to the EONIA rate is EUR22bn. Some 46 per cent of instruments linked to the EURIBOR rate and 77 per cent of those tied to the EONIA rate are expected to mature by the end of next year, which slightly reduces the scale of these problems.
Reform of WIBOR
The Benchmark Market Regulation did not foresee the developments on the money markets, and therefore also the scenarios that are currently most likely. For example, it allows for a situation where the benchmark may not be published. The market participants can then use a so-called expert assessment of its value. But the regulation did not foresee a situation where the benchmark disappears entirely, and it is not possible to prepare an expert assessment. The BMR also allows market participants to use the last reference rate that was announced for the valuation of the instruments. However, it did not predict a situation where the benchmark is announced for the last time — forever.
“The risk is that we will be using the last announced WIBOR rate for the next twenty years,” said Marcin Bartczak, from the Dentons law firm, during the European Financial Congress in Sopot.
The Polish interbank market, in which the WIBOR rate is used as the benchmark, is facing similar challenges. Although in Poland the nominal rates are not negative and we do not have quantitative easing, according to data of the Polish Financial Supervision Authority (KNF), at the end of 2017 there was EUR48bn in excess liquidity in banks. The participants of the WIBOR panel include the largest and most liquid institutions. This, in a way, explains why there are no transactions on that panel.
Towards the end of 2016, the duties of the administrator of WIBOR were taken over by the Warsaw Stock Exchange, and more specifically, by its subsidiary company, GPW Benchmark. It has to obtain the administrator’s license until the end of next year, and for WIBOR. If it fails to obtain these licenses, the WIBOR rate may continue to be announced, but it will be impossible to use it in contracts concluded after January 1st, 2020.
If WIBOR turns out to be incompatible with the EU law, banks should have a so-called continuity plan in place — a „smooth” replacement of the current benchmark. This involves knowing what the bank should do, if the benchmark undergoes significant changes or ceases to exist. Theoretically, WIBOR can still be used for contracts concluded until the end of 2019, even if it is not compliant with the BMR. But what will happen to the contracts, if one day the rate ceases to be announced?
WIBOR may also cease to exist because of the fact that out of the 11 banks participating in the panel, soon only 9 will be left due to takeovers. The bankers have no doubt — in the coming years the sector will experience a further consolidation. For the WIBOR reference rate to be announced, at least six banks submitting quotes are required to participate in the panel.
There is a rate but there are no transactions
Why is it possible that WIBOR may not obtain a license? Professor Aneta Hryckiewicz from the Kozminski University examined the impact of the bank tax, among other things, on the behavior of banks in the interbank market. It turns out that after the introduction of the tax on assets, banks ceased to conclude any transactions for tenors longer than one month. Let us recall, however, that the vast majority of loans granted in Poland use the 3M WIBOR (3 months) or the 6M WIBOR (6 months) reference rates.
“Transactions for maturities longer than one month are not functioning at all. The market for such tenors does not exist. On the shorter tenors you can see high cyclicality following the introduction of the tax. At the end of the month, the market also significantly decreases for the short tenors,” says Aneta Hryckiewicz.
Still towards the end of last year, GPW Benchmark published a document entitled „New documentation of reference rates”, which has been in force since February 1st, 2018. It consists several documents, such as the „WIBID and WIBOR Fixing Participant Code of Conduct” and „Regulations for WIBID and WIBOR Reference Rates”, which are essential for the transparency, supervision (also including internal supervision), and audit of the processes of submission of quotes by the panelists, as well as the relations between them and the administrator. The documentation ensures the compliance of the rules with the BMR and — which is also important — with the Market Abuse Regulation (MAR) which has been in force since mid-2017.
“We should appreciate what is being done now,” said Anna Trzecińska, the Vice President of the Management Board of NBP, during the European Financial Congress.
These changes are important, but the administrator, banks and the Polish regulators will face more challenges ahead. This results not only from the fact that there are no transactions on the market for longer maturities, but also from the fact that for many months all the panelists have been submitting the same quote, for example for the 3M WIBOR rate — at 1.7 per cent. This raises some questions: do all banks have identical financing costs over such a long period of time? Was the cost of financing over a period of several months for each of these institutions not affected by the observed price volatility, as well as the slowly but surely increasing volatility of deposit interest rates?
Who will determine the cost of money?
The interbank market rates are of crucial importance for asset valuation and for bank balance sheet management. Paweł Spławski, a Deloitte partner, said that if a bank had to change the current reference rate to a new one, this would entail a change in the valuation of its portfolios, such as debt securities. In the case the balance sheet items are balanced with derivatives, a change in the benchmark causes a high risk for the balance sheet.
“If we use one rate for the derivatives and the balance sheet is valued according to another rate, then this carries a huge risk,” said Błażej Wajszczuk from BGŻ BNP Paribas.
Therefore, the new benchmark should be ready and announced much earlier, and the smooth replacement of the old benchmark with the new one is crucial. However, the introduction must take some time.
“A benchmark is not something that can be sorted out on the spot,” said Andrzej Reich, a director at the Polish Financial Supervision Authority.
At the May meeting of the working group on EUR risk-free rates, a suggestion was made that the BMR should be amended. The representatives of ESMA and the European Commission participating in the meeting stated that this was impossible. Therefore, at least in relation to new contracts for all instruments, a new benchmark is needed in place of the reference rates that do not meet the requirements of the new regulation.
Although time is running out, there is still a possibility that banks will develop an alternative benchmark for the Interbank Offered Rates. They are required to do that by the BMR. “So far we have not found any bank in Poland that applies the regulations concerning the alternative benchmark. Besides, our entire region responded to the BMR as if it was not there,” said Dariusz Odzioba from PKO BP.
Vice President of the Management Board of GPW Benchmark, Aleksandra Bluj announced that the administrator would like to develop a Warsaw Repo rate, which would be based on secured transactions, and would therefore probably employ a methodology similar to the one used in the case of SARON.
The problem is that there are practically no transactions on the Polish repo market. This is in part due to excess liquidity, and in part due to the bank tax. It is designed in such a way that in the case of repurchase agreements the tax is paid by both parties. Additionally, Aleksandra Bluj acknowledges that for the time being basic methodological issues still have not been resolved. “We should ask ourselves what are we supposed to calculate. If the benchmark is to describe the effective cost of financing, we must answer which data should be calculated (…) The methodology of the new rate must describe the market in the best possible way. We must be prepared for a situation, where an entire family of indices is introduced,” she said.
Consequences for banks
Polish banks have two more problems than the financial institutions in the Eurozone. The first is that the WIBOR rate is the basis for the interest rates on the majority of consumer loans. While it is easier to build a benchmark for the purposes of balance sheet management or for portfolio valuation, even if it is a rate extrapolated from overnight indexed swaps (OIS), this is not the case when it comes to contracts with consumers. The latter have to understand the benchmark.
That is why a reliable measure of the bank’s financing costs is how much interest it pays its clients for deposits. The Financial Market Institute has collected historical data going back six years. Tomasz Mironczuk, the President of the Institute, believes that a benchmark can be built on the basis of these data.
The second problem for Polish banks is that outstanding loans denominated in CHF still amount to EUR23.2bn. On the other side of the balance sheet, the banks have instruments securing the provision of the CHF. They are all based on the CHF LIBOR, which will probably be replaced by SARON. But banks will not be able to automatically replace LIBOR with SARON in the agreements previously concluded with their clients.
“It seems to me that a legislative solution will be necessary,” said Marek Niechciał, the President of the Office of Competition and Consumer Protection, during the European Financial Congress.
There is one more option that should be taken into account. If there are no new reference rates, and the old ones are found to be inconsistent with the applicable law, the benchmarks — at least in relation to contracts with consumers — will have to be determined by central banks. It should be noted that although Swiss voters rejected the concept of “sovereign money” in the recent referendum, the very emergence of this concept and its significance, in essence boiled down to the question of whether banks shouldn’t be stripped of the function of money creation. The problems with the benchmarks indicate that banks may deprive themselves of the function of determining its price.