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1 Deutsche Bank Research Economics No. 60 MU Watch New reference rates in EMU The ECB s single monetary policy will lead to the emergence of a unified European money market rate. This will render obsolete all national reference rates based on central bank key rates or determined by the market. The replacement of the national reference rates (discount and Lombard rates as well as Fibor) in Germany has been regulated by the Diskont- Überleitungsgesetz and the Fibor-Überleitungsverordnung. The national, market-determined reference rates will be succeeded by Euribor and Eonia. For legal reasons, national interest rates will continue to be quoted in some countries. Euribor and Eonia will be the new benchmarks in the euro area. They will define the short end of the euro interest rate curve for all participating countries. A code of conduct will ensure transparency and safeguard Euribor s high quality. Its broad information base (57 banks on the panel) will make Euribor a representative money market rate in EMU. Euribor will compete with euro-libor which will be quoted in London. Euribor will enjoy a favourable starting position within EMU thanks to the fact that the minimum reserve requirements will not affect competition. Ellen Hörth, Frankfurt, (69) Policy Issues Capital Market Date November 27, 1998 Editor: Ulrich Schröder Tel.: +49 (69) Technical Assistant: Burgitta Scheurer Tel.: +49 (69) Internet:

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3 Introduction At the beginning of Stage III of European Monetary Union (EMU) on January 1, 1999 the national money and capital markets of the participating countries will merge into one European market, the second largest in volume terms after the US market. Even before the decision on the EMU participants in May 1998, capital market rates had virtually converged. Over the last few months, great progress has been made with convergence of Europe s money market rates. At the start of EMU, a unified interest rate will emerge on the money market. By contrast, the long end will continue to see rate spreads between the individual member countries, based first and foremost on differences in credit standing. Liquidity levels and availability of derivative products to hedge positions will also influence differences in yields. As a result of the harmonisation of monetary policy and money market rates in EMU, the current national reference rates will lose their reference status and new solutions must be found to fit the new EMU environment. At present, there is a variety of national reference rates, some of which are based on market conditions and standard usage, e.g. Fibor (Frankfurt Interbank Offered Rate), Pibor (Paris), Mibor (Madrid) etc., while others are set by the national central banks (e.g. discount and Lombard rates). The convergence of money market rates in the euro zone will render the quotation of national money market rates unnecessary. Definition Reference rates serve as a clearly defined point of reference for all market participants. Both market-based reference rates and central bank key rates can function as a gauge for interest rate conditions, and as a benchmark for financial products on the money and capital markets. In Germany, for example, the key interest rates are of great significance as the basis for the calculation of interest debt in roughly 60 federal laws and a large number of contracts. Hence, the terms at which the central bank offers or absorbs short-term liquidity are an important point of orientation for the formation of interest rates in the money market. A major role is also played by (interbank) market reference rates. They serve as indicators of the general interest rate level and reflect the terms at which banks lend to each other. In Germany this reference rate is Fibor (Frankfurt Interbank Offered Rate). It is used as point of reference in the fixing of prices for floating-rate notes or in swap transactions. In international transactions a large role is played by Libor, quoted in London for lending in different currencies and used particularly in the euromarket. What will change with the introduction of the euro? EMU will change the European interest-rate landscape. National money market rates will be replaced by the unified European rate which is now emerging. The Bundesbank will become part of the European System of Central Banks (ESCB). What does that mean for today s national key rates and reference rates? The ECB will steer the European money market rate first and foremost by means of open market transactions. Short-term money market rates will move within a corridor, with the interest rate of the marginal lending Convergence of interes rates in EMU member states Successors to national reference rates needed Reference rates may be key rates or market rates Changes to interest-rate landscape Economics 3

4 facility (at which banks can obtain liquidity overnight) as the upper limit and the deposit facility rate as the lower limit. The latter is the rate at which central banks may make overnight deposits with the ECB. How wide this corridor will be is unknown as yet. Money market rates, which will be determined above all by the rate for the main refinancing operations (weekly), will move within this corridor. This rate will signal the direction in which monetary policy is moving. Key interest rates The launch of EMU will mean the end of national monetary policy instruments. In Germany, all national regulations on discount, credit and open market policies (Bundesbank Act, Section 15) will be repealed. The resulting legal gap will be bridged by the Diskontsatz- Überleitungs-Gesetz (DÜG) (law on the transition from the German discount rate to a unified European key rate), which was passed on June 9, 1998 and deals with the replacement of the discount and Lombard rates as reference rates. Some form of regulation is needed as interest rates in numerous federal laws as well as contracts and other enforceable legal documents are determined on the basis of the Bundesbank s discount or Lombard rate. The present discount rate will be replaced by the so-called basic interest rate until December 31, The basic interest rate at the beginning of the three-year changeover period will be the discount rate of December 31, It will be adjusted three times every year (on January 1, May 1 and September 1) by the difference between the basic interest rate and the equivalent ECB instrument (provided the spread exceeds 0.5 percentage point). This ECB reference rate, which will determine the changes in the basic rate in the transition period from 1999 to 2001, has not yet been fixed. A draft regulation by the German Ministry of Justice suggests this should be the rate for the 3M standard tender which will be held each month. This rate may be volatile, as the transaction will in most cases be a variable-rate tender. It therefore seems less suitable as a reference point on a long-term basis. It also remains open whether an average interest rate or the rate on a particular date will be used to determine the basic interest rate (i.e. whether the rate for the April tender or the average for the January-April period will be used in the adjustment on May 1, 1999). Finally, the successor to the basic interest rate from 2002 must be laid down by law, as the DÜG expires on December 31, Until then, there will be time to monitor the functioning and effects of the instruments used by the ESCB before introducing binding legislation. This gradual procedure is designed to smooth the process of adjustment. The basic interest rate will be published by the Bundesbank (in the Bundesanzeiger, the official journal) on the specified reset dates. Likewise, the transition from the Lombard rate is currently under preparation. According to Section 3, DÜG, the Lombard rate may be replaced at an earlier stage, i.e. prior to 2002, by an ECB instrument, namely that whose functions bears the greatest resemblance to the Lombard rate. The Lombard-Überleitungs-Gesetz (LÜV) of which a draft has been submitted proposes that the Lombard rate be replaced by the rate for the ECB s marginal lending facility. DÜG regulates replacement of Germany s key rates Legislation needed for the period after 2002 Replacement of Lombard rate 4 Economics

5 Reference rates A successor must also be found for the national reference rates which have so far been determined by the market (e.g. Fibor, Pibor). They will be replaced by an EMU-wide reference rate, Euribor (Euro Interbank Offered Rate). This is the interbank interest rate for time deposits in euros. It will be quoted by representative banks participating actively in the euro money market. In Germany a regulation has been issued on the replacement of Fibor and Fiona. This Fibor-Überleitungsverordnung was formulated in the framework of the DÜG and passed on July 10, It lays down the following: The Frankfurt Interbank Offered Rate (Fibor) will no longer be used as reference rate; this function will be assumed by Euribor. The Frankfurt interbank offered rate for overnight money (Fiona) will no longer be used as reference unit; this function will be assumed by Eonia (Euro Overnight Index Average). Fibor-Überleitungsverordnung regulates changeover to Euribor and Eonia It has been agreed that Fibor will cease to exist at the end of The last Fibor fixing will take place on December 30, This will also be the first day of Euribor fixing. Calculation of the Euribor and Eonia reference rates Under the leadership of the European Banking Federation (FBE- Fédération Bancaire de l Union Européenne) and in co-operation with the Financial Markets Association (ACI), financial institutions in the EU have laid the foundations for new reference rates in the monetary union. Euribor and Eonia, the unified European reference rates, will replace the national rates of most of the participating countries on January 1, A joint code of conduct has been introduced for Euribor and Eonia in order to ensure that the new interest rates are of high quality and representative character. This code of conduct is a binding legal document, which for instance lays down the rules for determining Euribor and names the banks participating in the fixing. Only institutions of the highest credit standing and with an excellent reputation may be members of the Euribor panel; also, they must be among the most active participants in the money market. The panel of reference banks will, initially, be made up of 57 banks but comprise 64 banks once all EU countries have joined EMU. 47 of these banks will come from the euro area while 4 institutions will come from EU countries that are not yet EMU members. In addition, the panel will include up to six international institutions from non-eu countries. The number of banks per European country will be determined by the Euribor Steering Committee. The Steering Committee is a body composed of ten independent market experts. The 12 German banks make up the largest group on the Euribor panel. The decisive factor in determining the country quotas will be the importance of the individual financial centres in the member states. However, the national shares are not permanently fixed but will be reviewed periodically and may be changed. At the national level, the decision which banks will participate has been taken by the banking community. In Germany the Code of conduct ensures quality and transparency Representative banks on the Euribor panel Economics 5

6 selection was made by the Central Credit Committee (the federation representing the associations of the German banking industry). It has meanwhile been announced which banks will be represented on the panel (see table on last page). The code of conduct foresees that the composition of the panel be reconsidered by the Steering Committee after one year. Again, the decisive factor will be compliance with the code of conduct as well as activity in the euro money market and money market-related derivatives. For the Euribor calculation, the banks on the panel will provide Bridge Telerate (financial information provider) in Brussels with offered rates (rates at which a bank offers to lend) for interbank credit. This will be done on all TARGET business days, i.e. daily except on weekends, Christmas Day and New Year s Day, for 1-week as well as 1 to 12- month maturities. On the basis of this information, Bridge Telerate will then calculate arithmetic average interest rates for the different maturities to appear on its screens (page 248) throughout the world at 11 a.m. (CET). The first Euribor quotation will take place on December 30, Value date will be January 4, For the calculation of Eonia (Euro Overnight Index Average), the banks on the panel will provide the European Central Bank with their overnight rates. To be more precise, the banks will provide information on the effective rates at which they have lent overnight money to other banks up until 6 p.m. (CET). In addition, they will inform the ECB of the total volume of their unsecured overnight lending up to that time. Initially, the volume of repos (repurchase agreements) will not be included but may be part of the information provided later on. The ECB has agreed to calculate Eonia as the data provided by the banks is particularly market-related and thus confidential. The interest rates will be weighted according to the daily volumes so that the ECB will fix an effective, turnover-weighted Eonia overnight rate. It will be published by the FBE and ACI via Bridge Telerate (page 247). The rate is to be published before TARGET opens the next day. The first Eonia rate will be quoted on January 4, European money market rates: Euribor versus euro Libor The British Banking Association (BBA) has designed euro Libor, a eurodenominated version of the existing Libor, as a reference rate for 1- week and 1 to 12-month deposits. It will succeed the current Libor rates in the euro money market (DEM Libor, FRF Libor etc.). Moreover, a counterpart to Eonia, the Euronia, has been created so as to be able to offer an overnight reference rate, too. A closer look at the method of calculation reveals the conceptual differences between Euribor and euro Libor, or Eonia and Euronia. In contrast to the broad composition of the Euribor panel, as described above, euro Libor is based on information provided by only 16 Londonbased banks. This means that it provides only a much smaller-scale reflection of the interest rate level on the euro money market. Euribor: calculation and publication by Bridge Telerate Eonia: calculation by ECB, publication by Bridge Telerate London will quote euro Libor Different methods of calculation 6 Economics

7 EURIBOR (European Interbank Offered Rate) Euro LIBOR (Euro London Interbank Offered Rate) Panel banks Start with 57 banks, of which 47 from euro area, 4 from other EU countries and 6 from non-eu countries. The 16 most active banks in the London euromarket. Calculation By Bridge Telerate: excluding the highest and lowest 15%, an arithmetic average will be calculated, By British Banking Association: excluding the four highest and the four lowest rates, an arithmetic effectively including approx. average will be calculated 40 rates; publication of all 57 rates. from the remaining rates, effectively including 8 rates. Fixing At 11 a.m. Brussels time. At 11 a.m. London time. Decimal places 3 decimal places. 5 decimal places (subject to change). Days Day-count convention All TARGET business days, for the first time on December 30, 1998 with value January 4, Actual number of days divided by 360 (actual/360) with 2-day settlement. Publication Bridge Telerate, page 248, and on the pages where the current national reference rates are quoted. All TARGET business days, for the first time on December 30, 1998 with value January 4, Actual number of days divided by 360 (actual/360) with 2-day settlement. On the current Libor pages. EONIA EURONIA (Euro Overnight Index Average) (Euro Overnight Index Average) Panel banks As for Euribor. Brokers in London registered under the Financial Services Act. Calculation By the ECB: turnoverweighted average of all 57 rates provided, rounded to the next million, publication of the calculated rate and the volumes traded. By Wholesale Markets Brokers Association (WMBA), in cooperation with BBA: turnoverweighted average of unsecured overnight euro deposits. Fixing 6.30 p.m. Brussels time. No information available. Decimal 2 decimal places. No information available. places Days All TARGET business days, All TARGET business days. for the first time on January 4, Day-count Actual number of days actual/360. convention divided by 360 (actual/360) with 2-day settlement. Publication Bridge Telerate page 247, and on the pages where the current national reference rate are quoted. No information available. Economics 7

8 Will Euribor be accepted? For a new reference rate to be well received by the market, the following conditions must be met: The reference rate must provide a reliable reflection of the price level in the underlying market. An interest rate or an index provides a more accurate picture if it is calculated on the basis of abundant data. Thanks to the composition of the Euribor panel, which includes banks from all EMU member states and the remaining EU countries as well as international institutions from outside the EU, this condition will be fully met. The method of calculation, the circle of participating banks and the technical details should be made public at an early stage. This ensures the transparency necessary in financial markets and contributes decisively to the creation of confidence in the markets. This is guaranteed by the code of conduct of the banks on the Euribor panel and the information provided on a regular basis by the FBE. The latter has initiated marketing activities as well as the installation of a Euribor homepage 1) on the internet. In addition, a uniform reference rate implies that market conventions such as maturities and the method of calculating interest rates need to be harmonised. They will be based on recommendations by the ECB and the EU Commission, which have both come out in favour of using actual/360. To ensure continuity of contracts, details of the transition from the old to the new reference rates must be made clear well in advance. In Germany this has been achieved by passing the Diskontsatz- Überleitungsgesetz (DÜG) and the Fibor-Überleitungsverordnung. The replacement of former reference rates does not allow a unilateral, early termination or alteration of contracts (Section 4 DÜG). By contrast, consensual measures are possible, and even desirable for the adjustment of contracts to Euribor. Will euro Libor and Euribor rates differ? A particularly interesting point is whether euro Libor and Euribor rates will differ so that there will be two reference rates for the same currency. If the rates were indeed to differ, the markets could split into a domestic euro money market based on Euribor and an offshore euro money market based on euro Libor. One reason for rate divergence could be the timing of the fixing. While Euribor will be fixed at 11 a.m. Brussels time, euro Libor will be determined at 11 a.m. London time, an hour later. In addition, three other factors might trigger significant rate differences: minimum reserve requirements, differences in the credit standing of the banks involved, and liquidity bottlenecks on the market represented by the respective reference rate. Whether these aspects may actually justify a spread between Euribor and euro Libor needs to be examined more closely. Preconditions for the acceptance of Euribor Reasons for differences 1) For Euribor information on the internet, see 8 Economics

9 In the past the spread between DEM-Libor and Fibor (up to +/-10 basis points) was mainly due to the fact that there was no minimum reserve requirement for banks in London. The introduction by the ECB of an interest-bearing minimum reserve providing marketoriented remuneration for banks in the euro area means the end of this competitive distortion. The fact that the rate of interest corresponds to that of the ECB s main refinancing operations (refi rate) and the flexible handling (banks have to meet the reserve requirement on a monthly average) mean that the cost to be shouldered by the Euroland banks will be almost negligible. Moreover, minimum reserves may help stabilise money market rates. The ECB s decision thus creates a level playing field for the banks in EMU. Financial centres in continental Europe will not lose competitiveness. Another possible reason for a spread between the two rates could be a difference in credit standing of the banks on the Euribor and euro-libor panels. However, credit standing plays only a very minor role in short-term operations and will hence have no impact on the level of the reference rate. Also, the argument that the banks on the Euribor panel have a lower credit standing does not hold: one of the criteria for inclusion in the panel is a high credit standing. A comparison with the euro-libor panel reveals that a comparatively larger group of reference banks with a lower, i.e. an A-/BBB+ rating, takes part in the euro-libor fixing. This implies that the banks on the Euribor panel enjoy at least equal standing. Moreover, the Euribor and euro-libor calculations are adjusted for outliers. The Euribor fixing does not consider the lowest and the highest 15% of all reported interest rates across the maturity spectrum. The Euribor rate is hence effectively calculated on the basis of 70% of all data. The euro-libor consortium will ignore the four lowest and the four highest rates reported so that of the sixteen participating banks only eight actually take part in the fixing. Another argument that is frequently brought forward is a liquidity shortage or low level of liquidity in the Euribor-based money market, which might be seen particularly at the onset of monetary union. The declaration of intent of the Euribor panel banks represented in the steering committee, which states that they will change their mutually held Libor contracts to Euribor at the turn of the year, could create huge start-up liquidity for Euribor. In addition, the automatic changeover of contracts with the current national reference rates (Fibor, Pibor, etc.) will create an immense volume of Euriborbased instruments right from the start. The relevance of these arguments, which are often cited as reasons for a spread between Euribor and euro Libor, is therefore doubtful. Rather, we think there will be very similar or identical conditions across the maturity spectrum for Euribor-based products and euro-libor products traded off-shore. What will the market do? The new reference rates Euribor and Eonia will have to gain acceptance in the markets. This will hinge on the attitude of financial market participants. One decisive step towards the creation of liquidity is the recommendation by the panel banks to change outstanding contracts to the new rates. Minimum reserve requirement will not affect competition Criticism of credit standing unjustified Creation of liquidity High liquidity a precondition for success of new rates Economics 9

10 The European futures exchanges already offer derivative products based on the future reference rates. Eurex, the futures exchange which was created through the merger of Deutsche Terminbörse and the Swiss Soffex, offers both Euribor and euro-libor products. Futures contracts on the 1M and 3M Euribor have been on offer since September this year. In addition, there are options on the 3M Euribor future. Trading in 3M euro-libor futures started at the same time, replacing existing Libor transactions. London already offers its own euro-libor products. We would assume the continental European reference rates will be highly accepted in the money market. The swap market in particular will quickly opt for Euribor. Preparations for the changeover of Libor contracts to Euribor has already begun. Eonia will become the European reference rate for transactions in which fixed interest rates are swapped versus overnight rates on the money market. By including the sum of all lending transactions, i.e. market activity, it will take on a new quality compared with its predecessors. The situation in other member states As from January 1, 1999, Euribor will also replace the national reference rates in other EMU member states. The majority of these countries are currently making the legal preparations for the transition from the national reference rates to Euribor and Eonia, or have already passed these laws. In Spain and Portugal, the national reference rates will continue to be quoted for the time being, to provide reference values for existing contracts. Steps to deal with national deviations from the norm, especially the adjustment of market conventions, will be the task of national associations or lawmakers. BEF, PTE and IEP money market rates, for instance, are still calculated on the basis of actual/365. There continue to be differences in the fixing of settlement dates (T+1 instead of the usual T+2). It is striking that unlike in Germany a discussion on the replacement of the national reference rate by Euribor or euro Libor is not taking place in most of the other countries, or at least not as vehemently. This may be due to the fact that in these countries the national rates have played a greater role and have thus not competed to the same extent with the respective Libor rate. The replacement of these rates by Euribor is thus widely accepted. Derivatives trading already under way High level of acceptance expected Partner countries make arrangements for Euribor Ellen Hörth, Frankfurt, (69) Policy Issues Capital Market 10 Economics

11 EURIBOR panel banks Banks in Euroland Germany: Bankgesellschaft Berlin Bayerische Hypo- und Vereinsbank AG Bayerische Landesbank Girozentrale BHF-Bank AG Commerzbank AG Deutsche Bank AG Norddeutsche Landesbank DG Bank (Deutsche Genossenschaftsbank) Dresdner Bank AG Landesbank Hessen-Thüringen Girozentrale Landesbank Baden-Württemberg Girozentrale Westdeutsche Landesbank Girozentrale Belgium*): Bacob Générale Bank Kredietbank/Cera (KBC) Finland: Merita Bank Ltd. France: Banque Nationale de Paris Caisse des Depots et Consignations Compagnie Parisienne de Reescompte Credite Lyonnais Groupe CCF Groupe CIC Groupe Crédit Agricole Groupe de Banques Populaires Ireland*) AIB Group Italy: Banca Commerciale Italiana Banca di Roma Banca Nazionale del Lavoro Cassa di Risparmio delle Province Lombarde Credito Italiano Instituto San Paolo di Torino Monte Paschi di Siena Luxembourg: Banque et Caisse d Epargne de l Etat Banque Internationale de Luxembourg Netherlands: ABN AMRO Bank ING Bank Rabobank Austria: Bank Austria-Creditanstalt Group Erste Bank der Österreichischen Sparkassen Portugal: Caixa Geral de Depositos (CGD) Spain: Banco Bilbao Vizcaya Banco Central Hispano Banco Santander Ceca Corporacion Bancaria de España (Argentaria) Paribas Société Générale Banks from outside Euroland Members from other EU countries: Barclays Capital Den Danske Bank Midland Svenska Handelsbanken International banks from non- EU countries: Bank of Tokyo-Mitsubishi Chase Manhattan Cititbank Morgan Guaranty UBS/Warburg Dillon Read Bank of America *) In Belgium and Ireland the bank(s) indicated will rotate after six months with banks of equal size and standing, leaving the total number of reference banks unchanged. Economics 11

12 ISSN (in German: "EWU-Monitor") This series recently included the following topics: No. topics published on 62 ECB Interest Rate Outlook November 26, French institutional investors: a pivotal position in the euro zone November 23, New reference rates in EMU November 27, The effects of EMU on the structure on European banking October 2, EMU and Asia: Investment and trade relations in the euro era September 8, ECB Interest Rate Outlook August 28, The Growth Potential of Corporate Bonds in Euroland August 4, EU-4: Prospects for EMU entry and interest rate convergence July 17, The European Monetary Union - an American perspective July 15, UK: The long road to EMU June 26, Scenarios of withdrawal from EMU from a legal perspective July EMU - revolution for European financial markets May 7, ECB Interest Rate Outlook May 7, 1998 For price information and ordering, please contact: in Europe: in the USA: Deutsche Bank Research Deutsche Bank Securities Inc. Ms. Eva Lange Mrs. Barbara Rusinik P.O. Box 31 West, 52nd Street D Frankfurt am Main New York, NY Tel.: +49 (69) Tel.: +1 (212) Fax: +49 (69) Fax: +1 (212) in Singapore: in Japan: Deutsche Bank AG Asia Pacific Head Office Deutsche Securities Ltd. Mrs. Clarice Wong Ms. Midori Tanaka Temasek Tower Deutsche Bank Building 6F 8, Shenton Way, Toranomon Singapore Minato-ku, Tokyo 105 Tel.: Tel.: +81 (3) Fax: Fax: +81 (3) Internet: Publisher: Deutsche Bank AG, DB Research, D Frankfurt am Main, Federal Republic of Germany, editor and publisher, all rights reserved. When quoting please cite Deutsche Bank Research. The information contained in this publication is derived from carefully selected public sources we believe are reasonable. We do not guarantee its accuracy or completeness, and nothing in this report shall be construed to be a representation of such a guarantee. Any opinions expressed reflect the current judgement of the author, and do not necessarily reflect the opinion of Deutsche Bank AG or any of its subsidiaries and affiliates. The opinions presented are subject to change without notice. Neither Deutsche Bank AG nor its subsidiaries/affiliates accept any responsibility for liabilities arising from use of this document or its contents. Deutsche Bank Securities Inc. has accepted responsibility for the distribution of this report in the United States under applicable requirements. Deutsche Bank AG London and Morgan Grenfell & Co., Limited, both being regulated by the Securities and Futures Authority, have respectively, as designated, accepted responsibility for the distribution of this report in the United Kingdom under applicable requirements. Printed by: HST Offsetdruck GmbH, Dieburg. Print: ISSN / Internet: ISSN