ESTR- the new Euro benchmark is the ECB European Central Bank published in October 2019. Euro Short-Term Rate or ESRT is a risk-free rate and has completely replaced EONIA since January 2022. The transition has a significant impact on the Euro Zone Economy.
But what is ESTR and why it's important, and how does it affect the Forex market? In this article, we dig deep into the topic.
Before jumping into the definition of ESTR, first, you need to understand benchmark interest rates.
So let's look at what a benchmark interest rate is.
The benchmark interest rate is used to calculate the cost of borrowing money from different sources, markets, and entities. For example, they indicate how much it costs banks to borrow from one another and other sources like insurance funds.
This is also known as the reference rate and benchmark rate. This regularly updated interest rate is published by an independent body. A transparent methodology that is in line with the market trends is used to update the rates in a fair manner. Anyone can access the benchmark rates publicly.
These rates are used to calculate interest rates of loans, debts, mortgages, bank overdrafts, and deposits. Payments on options, swaps, and forward contracts like complex products are also determined using a benchmark.
A reliable benchmark rate ensures the legal certainty of financial transactions as it lowers the chance for either party involved in the contract to alter an agreed rate in their favor.
This is why organizations, as well as individuals across the world, employ a benchmark rate as a stand-on basis for calculating the interest of financial contracts.
On the other hand, an accurate benchmark rate helps better comprehend how financial markets work and how much money is available in the Eurozone. This helps central banks to assess and monitor the impact of monetary policy decisions and inform on the needed changes in policies.
So there is no question about the importance of a reliable benchmark rate that ensures smooth, transparent, and stable financial markets.
Currently, there are 3 mostly employed European benchmark rates, and ESRT is one of them.
The Euro Short-Term Rate (ESTR) is meant to indicate the payment banks inside the Eurozone should make to various financial counterparties for overnight funding. This is without providing collateral. Here a financial counterparty can be a bank, investment or pension fund, money market fund, the central bank, and other financial bodies.
So in simple words, it's the euro's overnight interest rate and indicates the average interest rate on loans over the course of a business day.
ESRT was developed by the ECB in 2017 and has been made available as a new benchmark rate since October 2019. The European Central Bank(ECB) sets and distributes the interest rate, which is a fixed rate.
ESRT was developed as part of the European Central Bank's policies to increase the transparency of benchmark indexes. It was created to replace the other mostly used benchmark rates, EONIA (Euro Overnight Index Average) and EURIBOR (Euro Interbank Offered Rate).
EONIA is calculated by taking the average of the interest rates on interbank overnight unsecured lending. Lendings of all the banks in the EU and European Free Trade Association (EFTA) are taken into account here, which is overseen by the ECB.
EURIBOR is determined by the average interbank unsecured short-term Euro lending interest rate. For this, only a selected panel of European banks participates. The daily reference rate is offered by EMMI, The European Money Markets Institute.
The main differentiation between EONIA and EURIBOR is the maturity of the loans on which they are calculated with. EURIBOR has different interest rates based on maturities on loans that range between one week and 12 months, while EONIA is a single overnight rate.
These two were the commonly used benchmark rates before ESRT. However, these benchmarks were not able to meet the requirements of the new Benchmark Regulations(BMR) of the EU. The regulations were published in 2016 and became effective in January 2018. The new regulation demands that interbank rates be calculated based on data and not estimates and surveys.
Another intention behind the replacement is to provide a fallback rate in case the private sector couldn't go with EONIA — their own overnight benchmark rate.
Although both EONIA and ESRT are unsecured rates, ESTER is calculated based on representative market data, thus making it BMR compliant. Thus the ESRT became the new benchmark rate for the EU(European Union) and EFTA(European Free Trade Association).
The other reason for switching to ESTR is due to the bank scandals(e.g.- the LIBOR scandal) that had occurred in the past when quote-based interest rates were used as a benchmark.
For this, they use the daily transaction information from the 47 biggest Eurozone banks. The data is obtained from money market statistical (MMSR) reports. However, here only transactions over one million euros are considered.
The rate covers the daily financing cost associated with credits during the workday. Every day, the ESTR rate is determined by the transaction chosen on the prior business day. This means the ESTR rate for the 1st of September 2022 will be determined based on the data of the 31st of August 2022.
Firstly the transactions are sorted in ascending order, then the top and bottom 25% are removed. Next, the mean of the remaining 50% is calculated and rounded to 3 decimal places.
Then the ECB published the rate before 9.00 CET on the next day along with the following details.
What makes ESRT better than the other benchmark rates? Does it have any downsides? Let's look at the pros and cons of this new benchmark rate.
When compared with LIBOR, ESRT is highly transparent. The LIBOR is calculated with regulated and secured data based on surveys.
ESRT is more straightforward in its calculation as it is based on information. Thus banks will have to send proof of their trades for verification rather than answering a question.
When compared to other benchmark rates, ESTR uses a high number of datasets.
Thus the rate reflects more information on transactions which increases the accuracy and precision of the benchmark rate.
The data used for ESTR is regulated by the Money Market Statistical Reporting Regulations of the EU — Meaning reduced opportunities for data manipulation, which increases the reliability of the rate.
This ensures financial stability, and the rate always reflects the most accurate money market data.
47 banks contribute data to calculate ERST, so more transaction data is used in the benchmark rate. This makes ESRT more representative of different market rates.
Although new reference rates in financial systems are not new, there is always a value risk when the rates are being changed over. When compared to EONIA rates, ESTR rates are much lower.
So rates mentioned in agreements are subjected to changes in order to standardize the procedure. With this, many borrowing contracts had to accept the new interest rates, which didn't end in favor of one party of the agreement.
EONIA is published around 19:00 on the same day. However, ESRT gets published around 09:00 on the next day.
The majority of trading/treasury and accounting systems are designed to calculate end-of-day valuation and perform P&L reporting on the same day, which requires the benchmark rate. Thus all the systems should be changed to suit the ESRT publication time, which comes the next day. And this has an impact on the monthly, quarterly, and yearly evaluations.
LIBOR, or London Interbank Offered Rate, is a benchmark rate introduced in 1986. The rate is calculated by taking the average of 35 different benchmark rates.
These rates encompass 5 major currencies — Euro, the US dollar, the British pound, the Japanese Yen, and the Swiss Franc.
This benchmark is determined very differently from other new benchmark rates, including the Ester, which are often based on transactions.
Data for LIBOR is obtained from a survey where they ask about the interbank money lending rates at a specific time. Then 25% from the top and bottom is trimmed off, and the mean rate of the remaining 50% rates is used to determine the average rate.
LIBRO was globally used as a benchmark rate in ensuring the security of financial contracts. However, the rate started to decline after the scandal in 2011, as some major financial institutes manipulated the rate for their own gain. After this, demand for transaction-based systems, such as ESTR, increased.
Interest rates rule the forex market. Although the central bank's interest rates have the biggest influence on the market, benchmark interest rates also have an impact on Forex.
Benchmark rates are employed across financial markets ranging from deposits, fixed income, credit market products, and more. The rate is a good indicator that showcases the strength of the economy of the Euro Region, which is why the benchmark interest rate is taken into account in the fundamental analysis in trading.
In Forex, economic, political, and social factors have significant weight when evaluating the relative currency value.
Benchmarks are used throughout the economy in the EuroZone. Thus, it's a macroeconomic factor that affects the region's economy significantly.
On the other hand, the Benchmark rate also affects the swap rates in Forex.
Reference rates are important for the determination of Swap rates. Just like LIBOR or Euribor, ESTR also has a swap curve that affects the valuation of interest rate swaps.
Apart from this, the transition to the ESTR curve will also impact the value of interest rate swaps which you need to keep in mind.
It is the new benchmark rate for calculating the interest of overnight borrowing between banks within the Eurozone. The rate was employed in 2019, replacing the EONIA.
Yes, the ESRT or the euro short-term rate is considered the risk-free rate for the euro Zone.
Yes, on 2nd October 2019, ESRT was published by the ECB for the first time. It was introduced as the alternative euro risk-free rate to replace EONIA, where the ECB gave time till January of 2022 for the financial institutes to make the transition.
A full transition to ESTR from EONIA was demanded by the ECB by January 2022. Although the timeline was tight, the transition was smooth and completed successfully as planned, maintaining financial stability and monetary policy.
The new benchmark rates were introduced as a backup for EONIA. However, during this short period of time, ESTR became the primary overnight euro unsecured rate, with the high preference shown by the financial industry for ESTR over EONIA.
This is due to the reliability and robust nature it has shown since its launch while accurately representing the market trends in the EuroZone.
Today, ESTR is the main euro overnight risk-free rate and will also serve as the fallback rate when the EURIBOR is discontinued (eventually). The use of the ESTR as an alternative to EURIBOR in additional market segments may grow in the future.
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