Europe’s central banks have warned that the inflation battle continues as recession fears persist, triggering fresh uncertainty over the region’s interest rate outlook. Against this backdrop, investors need a quick and reliable way to hedge their risk. Growing divergence between U.S. and European monetary policy was underscored in December, with the U.S. Fed indicating they expect to cut rates by ~75 basis points in 2024 while the European Central Bank and Bank of England cautioned against complacency on consumer price pressures. In the same month, ICE Euribor options saw single day volumes hit 1.58 million - their highest volume day in over a decade - while Euribor futures traded over 3 million contracts the day that central banks released their decisions (see Chart). Open interest in the options market remains around levels not seen for a decade, as the interest rate cycle drives demand.

As a key bank-to-bank lending rate, the Euribor benchmark is used across trillions of dollars of financial instruments in the global system. It has provided reliable liquidity throughout periods of market uncertainty, including times characterized by low market activity - like the COVID-19 pandemic - or high volatility, such as rapid tightening in Europe’s monetary policy.

In December 2023, the European Securities and Markets Authority (ESMA) Euro Risk-Free Rates Working Group announced that European Union interest rate reform was complete. The group noted Euribor’s “systemic importance” in the EU, and that the benchmark is here to stay. “In the bond and loan markets, the predominant benchmark remains EURIBOR, reflecting both the continued availability of EURIBOR and preferences of the majority of market participants” the group said.

The methodology which underpins Euribor continues to be strengthened. As Euribor’s administrator, the European Money Markets Institute (EMMI) recently completed a consultation that aims to diversify its panel of banks to provide a broader picture of euro-denominated lending costs. In addition, EMMI aims to reduce the burden on firms which already contribute to Euribor’s calculation by using a standardised approach. Proposed changes could take effect this year.

Euribor operates in parallel with the latest risk-free overnight rate, €STR (euro short-term rate) which reflects the actual overnight borrowing costs of banks within the eurozone. Both interest rate benchmarks serve a purpose, and the market continues to support Euribor futures and options contracts.

Familiarity, simplicity and flexibility

Familiarity is a key reason why Euribor endures as an interest rate benchmark. Euribor contracts are well understood by market participants, which carries weight in an uncertain economic environment. This understanding leads to support, creating a transparent and fair market that aims to retain investor confidence.

Simplicity is another factor. Euribor term rates out to 12 months make it easier for corporates to hedge their interest rate risk compared to the more complex calculations that accompany a risk-free overnight rate. It allows them to focus on their core business, rather than concerning themselves with the nuances of various financial markets.

There is also an element of flexibility to the Euribor benchmark. It has a built-in credit component because it represents an uncollateralized cost of borrowing by a bank. Many market participants believe that a short-term rate with an inbuilt credit component better serves the needs of lenders and borrowers. Amid a backdrop of higher interest rates, this component becomes even more important for price discovery of risk.

Therefore, Euribor provides trading opportunities for market participants, allowing them to take leveraged positions in a more cost-efficient way. The result is greater liquidity across the entire market, reducing costs for all participants.

A strong, diverse participant mix

The sheer diversity of participants in ICE’s Euribor’s derivative markets underpin its strength. It’s a mix which includes banks, asset managers, algorithmic traders, hedge funds, proprietary traders and other market participants which need to manage their risk. Across financial markets, the ability to quickly enter or exit a position is crucial in periods of instability, and the depth of Euribor’s liquidity provides assurance to market participants.

EMMI chief executive Jean-Louis Schirmann says, “Published since 1999 in parallel with the introduction of the euro, Euribor has withstood various global crises and proven its robustness. The current structure of Euribor relies on a three-level waterfall methodology. EMMI is currently suggesting a modification in which Level 3 would be eliminated, thereby reinforcing the model-based and formulaic approach in Level 2 calculations. EMMI conducted a public consultation on this matter in the last quarter of 2023 and is now analysing the comments received. The proposed changes aim to ensure Euribor’s sustainability, representativeness, and transparency.”

As investors grapple with a vacillating rates backdrop and high inflation, the depth of Euribor liquidity is set to play a key role in helping them manage market uncertainty.