Saturday, 11 January 2020

EURIBOR: The market does not believe in ISDA fallback in the next 10 years!

ISDA has launched a couple of weeks ago a new consultation related to IBOR fallback. This consultation is related to EUR-LIBOR and EUR-EURIBOR (and undisclosed other IBORs!). In the previous blogs about the fallback over the last 2 years, we have not provided any figure for EUR. The reason was two fold: we don't really believe in imminent EURIBOR fallback and the EUR rate market has been completely dormant for several years and it is very difficult to read anything in that market.

With the questions about the EUR fallback coming to the fore, it is a good time to try to read something from the market rates.

The conclusion is the title of this post:
The market does not believe in ISDA proposed fallback for EURIBOR in the next 10 years!

The conclusion is intentionally ambiguous. It can be read that the market does not believe that the ISDA proposed fallback methodology will be adopted in the next 10 years or that there will be no requirement for a fallback in the next 10 years, i.e. that EURIBOR will survive that period.

Before explaining the conclusion, we need to describe the data and the premises of the analysis. The data is based on historical ESTR (and pre-ESTR) figures, historical EURIBOR and current basis spread market.

The ESTR benchmark was officially started on 1 October 2019, but ECB has published pre-ESTR figure with values dating back to 15 March 2017. If we include the pre-ESTR figures in the analysis that is almost 3 years of data. Without the pre-ESTR data, there is a little bit more than 3 month of data, this is not enough to compute one single ESTR compounded in arrears for one 6-month period! The pre-ESTR figures are, according to the ECB, not intended for use as a benchmark in any market transaction, whether directly or indirectly", but are acceptable for personal analysis.

With the ESTR data, I have computed the composition on EURIBOR periods 1, 3 and 6 months. The computation is done using the open source code that I have posted in February 2018. The ESTR compounded rates are then compared to EURIBOR and median is computed (using code posted in Marc's Analysis repository:

The historical time series of ESTR compounded are represented graphically in the figures below. The full data is also available in the analysis repository described above.

Figure 1: Time series of EURIBOR and (pre-)ESTR compounded with 1-month underlying period.

Figure 2: Time series of EURIBOR and (pre-)ESTR compounded with 3-month underlying period.

Figure 3: Time series of EURIBOR and (pre-)ESTR compounded with 6-month underlying period.

As can be seen in the data, there was very little volatility in ESTR and in EURIBOR and consequently very little volatility in the relevant spreads.

Let's look at the 1-month, 3-month and 6-month tenor spreads against ESTR compounded in arrears. The medians are 7.95 bps, 12.41 bps and 18.06 bps. Those medians are the relevant figures for the ISDA fallback methodology. Those spreads imply a 6-month/3-month basis spread of 5.65 bps.

What is the market saying? Looking at the 10-year tenor basis swaps, we see a spread of around 6.20/6.50 bps. That seems roughly in line with the above computed spread. Two possible explanations for that figure: the market believe in the imminent fallback of EURIBOR to ESTR using ISDA proposed methodology for the spread or this is a coincidence. To decide between the two, let's look a the spread curve shape. If EURIBOR fallback to ESTR + spread in the next 10 years, the fallback being definitive, it will still be there in the 20 following years. What is the 30-year tenor basis spread? The spread is just below 3 bps. A back of an envelop computation give a spread of around 1.25 bps for the 20 years between 10 and 30 years. Definitively the market does not indicate an expectation of the ISDA proposed fallback to apply to EURIBOR in that period.

Maybe we are missing something in the computation. The market may expect the spread implied by the realized LIBOR/ESTR fixings to decline to a small figure in line with the long term quoted spread. But the spread for the 10-year tenor basis swap is around 6.5 bps, the market expect that spread to be realised, so it expect that the spread on the ISDA proposed 5-year look-back spread will be around that figure.

We are oversimplifying the story in the above paragraph. The market 6.5 bps is an average in the risk neutral measure but the historical spread is a median in the historical measure. Can the difference between the two explain the difference? If yes, would it make sense to try to statistically arbitrage this difference?

Another issue is that the ISDA proposed spread is based on realised spreads between forward-looking LIBOR and realized backward-looking compounded ESTR. The spreads contain the credit and liquidity spreads but also the misestimation by the market of the forward looking rates with respect to the backward looking ones. The market may have an estimation of the market misestimation that explain that difference (!).

We are digging quite deep to try to find an explanation. Even if the above explanations are theoretically possible, they seem far fetched. The best explanation seems that
The market does not believe in ISDA proposed fallback for EURIBOR in the next 10 years!

Is it the expectation of a different fallback or the expectation of the EURIBOR to survive for another 10 year? We don't know. We expect EURIBOR to survive at least to 2027 (2022 + 5 year) if a clean transition (including a clean fallback) is not developed in the mean time.

Note: Other long term spreads do not match our computed median spreads:
1Mv3M: historical 4.46 bps - 30Y basis swap 2.3/2.9 bps
ESTRv3M: historical 12.41 bps - 30Y basis swap 8.5/9.1 bps

Maybe there is a way to make money on EURIBOR fallback.