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ECB Tiering Implementation Analysis Summary

Core Content Overview

This document discusses the potential impact of the European Central Bank (ECB) introducing a tiered deposit facility, with a particular focus on the transition from Eonia (Euro Interbank Offered Rate) to €STR (Euro Short-Term Rate). It also examines the implications of this change on market rates such as OIS ( Overnight Index Swap) and BOR (Benchmark Overnight Rate), and considers the effects on interbank and non-bank financial institutions.

Key Messages

• Risk of Eonia Spikes: A potential risk of introducing tiering is that it could lead to an increase in Eonia, which might tighten OIS/BOR spreads.
• Impact Mitigation: The ECB plans to redefine Eonia as a fixed spread to €STR starting from 2 October 2019. This redefinition is expected to reduce the impact of tiering on Eonia and OIS/BOR bases.
• Volatility Concerns: The introduction of tiering could create volatility in Eonia just before the transition to €STR, which the ECB aims to avoid.
• Timing of Tiering: Tiering is unlikely to be introduced before October 2019, but it may be preannounced to allow for market adjustment and ECB rate policy flexibility.

Main Concerns and Analysis

Tiering and Arbitrage

• Arbitrage Risk: The ECB is concerned that tiering could lead to interbank arbitrage, where core banks lend to peripheral banks at attractive rates, potentially driving up Eonia.
• Eonia vs. €STR:
  • Trimming: €STR includes significant trimming (50% total), making it less susceptible to arbitrage effects compared to Eonia.
  • Coverage: €STR has a much broader coverage (around EUR35bn) than Eonia (around EUR3bn), diluting the potential impact of tiering on Eonia.
  • Non-Bank Involvement: €STR includes non-bank financial institutions, which are not ECB counterparties and thus cannot arbitrage in the same way as banks.

Market Impact

• Reduced Impact: Due to the differences between Eonia and €STR, the impact of tiering on forward Eonia and OIS/BOR bases is likely to be less than market expectations.
• Peripheral Banks: Peripheral banks may repatriate funds from the ECB if the tiered facility offers better rates, but this does not necessarily mean a rise in overall excess liquidity.
• Market Volatility: The ECB may limit the impact of tiering by setting the upper tier rate based on previous balance levels, similar to the Bank of Japan's approach.

Likely Timeline for Tiering Introduction

• Transition Date: Eonia will be redefined as a fixed spread to €STR starting from 2 October 2019.
• Tiering Delay: Tiering is unlikely to be introduced before October 2019 to avoid unnecessary volatility in Eonia/pre-ESTR spreads.
• Preannouncement Possibility: Tiering could be announced earlier, possibly in mid-late October, to provide market guidance and allow for rate adjustments.

Important Disclosures

• Non-Independent Research: This document is non-independent research and is intended for professional clients and eligible counterparties.
• Marketing Communication: It is a marketing communication and not investment research.
• Confidentiality: The information is provided on a confidential basis and may not be distributed without prior consent.
• Legal Restrictions: The document may contain performance data based on back-testing and is not a prospectus or public offering. It does not constitute investment, tax, or legal advice.
• US and UK Disclosures: The document includes important disclosures for U.S. and UK markets, including those related to options, ETFs, and convertible securities.

Conclusion

The ECB's transition from Eonia to €STR is expected to mitigate the potential negative impact of tiering on Eonia and OIS/BOR spreads. The broader coverage and trimming of €STR reduce its vulnerability to arbitrage, making tiering more likely to be implemented after the transition. The timing of tiering introduction is expected to be carefully managed to ensure market stability and to allow for adequate preparation and adjustment.