European Central Bank Launches New Reference Rate After Failed Reform

On Thursday, the European Central Bank announced that it would develop a new overnight reference interest rate by 2020 after the failure of industry players to repair existing facilities that were struck by fraud and declining liquidity.

Benchmarks like that of the Euro Overnight Index Average (Eonia) and the Euro Interbank Offered Rate (Euribor) are used to price trillions of euros worth of derivatives and calibrate monetary policy. In some countries, it is also used to determine the interest rates on mortgages.

However, confidence in them has declined as accusations of fraud, and lower volumes increased the spectre of distortions that could have an effect on asset prices and prevent the transmission of the monetary policy of the ECV to the real economy.

“Both benchmarks rely on the voluntary contributions of two distinct panels of banks, the number of which has fallen sharply in recent years,” stated the ECB.

“The (new) interest rate, which would be produced before 2020, would complement existing benchmark rates produced by the private sector and serve as a backstop reference rate,” said the statement of the ECB.

The statement also said that the power of the ECB to replace the existing benchmarks is limited since rates on longer maturities can only determine overnight maturities could be interpreted as a desired policy stance.

In order to provide an alternative for the longer-dated Euribor, The ECB added that it would work together with other European agencies, such as the European Commission, to distinguish a new rate that may serve as a benchmark.

The agencies said that the said working group might choose the new rate of the ECB as its overnight benchmark. However, it could also opt for an alternative as they decide on one or more reference rates.

The European Commission reckons that Euribor underpins contracts with a nominal value of around 180 trillion, making it an important instrument.

But industry-led reform failed when the bank complained that a new transaction-based system would have an excessive impact on volatility, rate levels, and transaction volumes.

“It appears that currently there are not enough transactions to construct purely transaction-based longer-tenor reference rates,” said the ECB.

“This means that some expert judgment may be required in order to sustain daily benchmark publications on such tenors,” stated the ECB. “Such judgment cannot come from a central bank.”