The recently unveiled plan of European Money Markets Institute (EMMI) to enhance the robustness and viability of Euro Overnight Index Average (EONIA), one of the major reference rates in European money markets, is a welcome reassurance to the investors and the global economic structures at large. The plan to strengthen and overhaul this critical benchmark which serves the overnight unsecured interbank lending is part of the string of initiatives from benchmark regulators post-crisis. The recently announced Sterling Overnight Index Average (SONIA) reform from Bank of England, for example, is in similar taste.
EMMI has launched a similar program with comprehensive reforms for systemically significant EURIBOR benchmark over the past three years. EONIA too, has been a beneficiary of these reforms in the form of policies, procedures and control frameworks being under the same administrative umbrella. However, at a time when regulators around the world are actively pursuing programs related to Alternative Risk-free or nearly risk-free reference rates, and given that EONIA is the designated nearly risk-free reference rate for EU, the need for an exclusive and independent reform for the benchmark was imminent.
A study undertaken by EMMI shows that the number of panel banks with positive volume submissions for EONIA have fallen over the years - 69% in 2009 to 44% in 2015. A clear signal of decline in the activity in underlying money markets, this affects the long-term viability of the benchmark. Given the critical role of EONIA in european money markets coupled with the decline in non-zero volume submissions, EMMI is undertaking a stand-alone review of this overnight benchmark.
First leg of this reform process involves strengthening the current processes surrounding the benchmark determination and administration. The underlying objective is to review and transform EONIA to the standards prescribed in IOSCO principles (Governance, Quality of Benchmarks, Quality of Methodology and Accountability) and ensure adherence to the upcoming European Benchmark Regulation. The recently published review of administrator compliance on IOSCO principles for IBOR+ benchmarks showed a positive movement in the direction of fortifying the critical financial benchmarks. The ongoing reform activity of EONIA, which may be deemed similar in its intent and approach, is expected to yield similar benefits as well.
The activity in this phase necessarily translates to:
An overhaul of code of conduct and obligations for all the stakeholders of the benchmarks such as administrators, calculation agents and contributors
Review and Enhance existing governance, policy and procedural frameworks
Document and review of current benchmark determination methodology - A preliminary study limited to identification of contingency triggers and fallback arrangements for periods of market stress or data insufficiency.
With regards to the contingency triggers and fallback arrangements, Article 6.3 of European Benchmark Regulations states that the administrators’ control framework shall include “contingency procedures that are in place in the event of a disruption to the provision of a benchmark”. In accordance with this, EMMI launched a high-level analysis of benchmark rate and underlying submission activity proposing a contingency trigger of 4 non-zero volume contributors on a given day. Upon activation of such a trigger, a WVAR (weighted volume average rate) formula based fallback arrangement is utilised to derive the benchmark rate and published with a notation indicating the same. Though, the above mentioned points are recommended by EMMI, they are open to discussion as EMMI has invited stakeholder response on the same by September, 2016.
Conducting an extensive analysis of unsecured short-term money market activity, reviewing and enhancing the benchmark determination methodology form the second leg of the reform process. This is envisaged to extend into 2017 and may necessitate further stakeholder consultations on the nuances of evolving the EONIA determination methodology. The objective of this phase is to ensure that the changes proposed to the methodology are inline with the underlying market the benchmark represents and that the integrity, robustness and reliability of the benchmark is maintained.
While the reform activity for EONIA is not unique in its intent, it is nevertheless crucial one at this juncture when regulatory authorities across major financial markets are consolidating on financial benchmark renovations. This activity assumes special importance when analysed from the view of regulatory efforts to reduce market dependency on singular representative benchmarks by identifying risk-free or nearly risk-free alternative reference rates promoting market choice. EONIA is the designated nearly risk-free reference rate for EU unsecured markets with similar work in motion for secured markets as well. The Alternative Reference Rate Committee (ARRC) of United States, National Working Group of Switzerland, Study Group on Risk-free Reference Rates of Japan are all essentially varied flavours of this very intent.
There is no denying that the amount of activity witnessed in Financial Benchmarks space in the recent past has been enormous. From the banks and financial institutions’ perspective, it may seem like a gigantic puzzle with lots of moving pieces with new pieces added everyday. Anticipating, analysing and applying these regulatory changes to their business in the form of contribution or consumption practices requires nimble and diligent efforts - An essential process of Continuous Compliance. From the investor perspective, however, this heralds the dawn of transparent, reliable and robust financial benchmarks and markets, free from the shadows of past with the promise of hopeful future.