ANALYSIS: European debt market to use ESTR, Euribor for a while

Speaking at the Eurex Derivatives Forum last week, a panel discussed fragmentation in the European bond market which has been exacerbated in recent years by the emergence of the Euro short-term rate (ESTR), the risk-free alternative to the main Euribor benchmark.

Sören Kretschmar, director, head of Bond Derivatives Trading at Deutsche Bank, told the delegation moving liquidity from one reference rate to another is notoriously hard to do without a regulatory mandate to force the change.

Kretschmar told the conference: “The market is definitely not pricing a transition from Euribor to ESTR any time soon otherwise we wouldn’t have had some distortions at the long end. So we are not seeing a move like we have seen in other economies.”

The US and UK have moved in recent years from their legacy, Libor-based rates to risk-free rates but Europe has not taken (and is looking increasingly unlikely to take) this step, hence its two rates.

Kretschmar added: “For the banks it is a market that is traded so there is revenue to be made. The push will not come from the banks - it needs to be regulatory driven or the issuers themselves need to start using this rate more.”

Thilo Rossberg, head of Traded Markets at LBBW, agreed with his counterpart: “It’s either the regulator pushing for it or it’s going to stay that way for the foreseeable future. Even though we all suffer from the unpredictability of the fixings, there is still a high demand for knowing upfront the term interest rate period in the real-world economy.”

The ESTR rate has built some momentum despite the lack of a regulatory mandate but Rossberg said the risk-free rate has not passed a crucial tipping point: “I don’t think a lot of bank treasuries have switched over to an ESTR-based ALM strategy, rather they are stuck to the Euribor-type of swap reference. Hence, only in the short-term, do we have the ESTR products and the ESTR mindset.”

Lee Bartholomew, global head of FIC ETD Product Design at Eurex, stressed the differences between the two rates, including the fact Euribor has a credit component and ESTR does not.

He told the delegation: “If you look at what’s trading in the front end, so that’s zero to three years, you’re seeing increasing flow from hedge funds to trade the basis such as ECB dates versus ESTR OIS (overnight index swaps).”

Bartholomew added: “There’s a natural need to hedge the ESTR component but right now the go-to market is Euribor, trade the basis and switch some risk over.

“To Sören’s point, where you’ve got swaps issued in Euribor, that’s going to be difficult to convert the market across without the regulator saying this is the date, because that is what focuses people’s attention. So we’ll see the two markets co-exist.”

Bartholomew went on to say there isn’t an active ESTR options market because banks are not building structured products based on ESTR, which is another key component.

Siegfried Ruhl, Hors Classe Adviser Directorate General for Budget at European Commission, said the European Union is ramping up its issuance of EU bonds which will inevitably create demand for EU bond futures, which Eurex is currently working on.

Ruhl told the conference: “We are talking about fragmentation and vulnerability, if we want a European safe-asset, the capital markets have to treat it like one.”

He went on to say the European Commission and the industry need to work together to create the ecosystem for EU bonds and their futures.

“Market participants have to reflect this in risk policies, collateral agreements, investment policies, benchmarks and indices. You can issue trillions of a bond but, it will never become a liquid safe-asset, if you don’t treat it like one.”

The European Commission proposed on Tuesday a plan to borrow up to €150bn (£158bn) as Europe moves to increase defence spending to support Ukraine’s war against Russia.

The European fixed income market will be discussed further at the FOW Amsterdam conference on April 3.