Why are reference rates important?
Reference rates are important because they offer standardisation. They lower transaction costs in the financial sector and mean parties do not have to negotiate a reference point for calculations in each financial contract. Reference rates such as EONIA, LIBOR and many other benchmark rates in the financial markets are therefore used for many different products. Professional investors use these benchmark rates to, for example, determine the variable interest rate that applies to interest rate swaps. However, consumers also have products that are linked to reference rates, such as variable rate mortgage loans.
Towards the €STR
In response to tightened regulations, there will be global reform of the most important benchmark rates. The most significant new requirement is that as of 2022, the reference rates must be based on transactions instead of estimates provided by money-market brokers, which are prone to manipulation. The two most important reference rates in the euro area, EONIA and Euribor (with maturities from one week to one year), fail to meet these criteria in their current state. While Euribor can be reformed to comply with the new requirements, an alternative has been developed for EONIA: the €STR.
It is based on the price of transactions that are submitted daily by the 50 largest banks in the Eurosystem – over the coming years this will be expanded to include transactions from other banks. Compared to EONIA, the €STR is underpinned by a broader range of financial transactions. To determine the €STR, the transactions between banks and other financial institutions, such as insurance companies that make overnight deposits at banks, are also included. The €STR also measures the interest rate that banks pay to financial market participants for unsecured overnight deposits, while EONIA measures overnight lending transactions. As a result of these differences in methodologies, the €STR rate now stands at approximately 8.5 basis points (0.085 percentage points) lower than the EONIA rate (see figure 1).
Figure 1 – The €STR is less sensitive to non-standard transactions than EONIA (in %)