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Four Key Questions on European Overnight Rates

Chris Farran, CME Group


  • CME Group RepoFunds Rates and the European Central Bank’s €STR are both important overnight interest rates for the eurozone
  • RepoFunds Rates are secured, reflective of the credit quality of their respective countries, and responsive to ECB policy

Since mid-2022, the European Central Bank (ECB) has been in a tightening period in response to inflation. As of February 8, the ECB has implemented five consecutive rate increases, landing its deposit facility rate at 2.5%, its highest level since 2008. More rate increases are expected, and all are affecting the overnight rates market.

Overnight interest rates measure the cost at which market participants access short-term funding and are thus critical to the health of a given financial system. These markets are a key contributor to economic activity: financial institutions use overnight rate markets to finance their daily operations, and then in turn provide financing to the clients they serve. This also makes the overnight rate markets a key player in central banking operations as the mechanism for tightening or loosening monetary policy is to implement policies that increase or decrease the value of overnight rates.

The eurozone has two major overnight rates: the Euro-Short Term Rate (€STR) and the RepoFunds Rate (RFR). Both are important measures to watch in determining the path of rates and the economic outlook for the euro area.

With the launch of €STR and RFR futures, CME Group offers direct trading for three key eurozone overnight rates: €STR, RFR Germany and RFR Italy. Visualizing these rates over time highlights the interesting details that define them. This article will answer four questions that address the unique nature of the chart below:

Why is €STR Consistently Higher than RFR?

€STR measures the cost of unsecured overnight borrowing costs between financial institutions in the eurozone. The transactions are thus based on overnight loans between financial institutions with no underlying collateral securing the loan. These transactions occur between financial institutions that have a surplus (the lender) or a shortage (the borrower) of cash at the end of their daily operations.

CME Group RFR are regulated benchmarks measure the cost of secured overnight borrowing between market participants using sovereign bonds as the underlying collateral in the loan. These transactions occur via repurchase agreements, often referred to as “repo”. In this market, the borrower provides the government security to the lender for collateral and then receives it or a like security back at the end of the agreed loan or repo term (for RFR transactions, this term is one day).

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The annualized rate between the initial sale and the subsequent re-purchase price is known as the “repo rate”. RFR Germany refers to transactions secured with German government bonds, RFR Italy with Italian government bonds, and so on. Eligible transactions are the aggregate of overnight, tomorrow-next, and spot-next trades with the same start and end value dates.

Given that repo transactions are usually short-term and collateralized by high-quality government bonds, the repo rate is generally thought to represent the cost of the safest form of borrowing. The extent to which a given sovereign RFR transaction is safer than an €STR transaction can be expressed via the spread between the two rates, allowing market participants to see how the market prices credit between eurozone countries in real time.

Why do RFR Values Vary Between Sovereign Countries?

Because RFR values are derived from secured repo transactions, they are heavily affected by the credit rating of the collateral used in the transaction. RFR trades are also centrally cleared (and thus anonymous), removing counterparty credit risk – this ensures that their values reflect the credit quality of the underlying collateral and not potential counterparty risk.

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There is relatively wide dispersion between the credit quality between eurozone countries despite using a common currency. Germany and Italy represent the “bookends” of the credit quality range, with Germany being one of the highest rated countries and Italy being one of or the lowest rated depending on the rating agency.

The spread between RFR values represents the risk premium between a different sovereign collateral. As expected, repo transactions secured by German government debt represent the safest form of secured borrowing in the eurozone, Italy the lowest, with France in between.

Why do RFR Values Decline Periodically?

Recall that repo transactions are secured by government bonds. Collateral used in these transactions are referred to as one of two descriptions: general collateral and special collateral. These are technical descriptions and refer to the relative scarcity of the bonds used in the transactions; when bonds are not in particularly high demand they are “general collateral.” When they are scarce and in high demand, they become “special collateral.”

In Europe, financial institutions usually freely lend out bonds in their inventory into the repo market. However, during quarter and year end, financial institutions prefer to keep high quality government bonds on their balance sheets as these time windows coincide with regulatory reporting cadences. Their unwillingness to lend these bonds into the repo market at this time results in relative high demand for them, and they become “special collateral.”

This is the phenomenon that happened throughout the period shown in Figure 4 below. Specialness often reduces financing rates into negative territory.

Why do Both RFR and €STR Increase Over Time?

As evident in Figure 1, €STR moved in a lock-step fashion throughout the period shown, whereas the three RFRs moved in a sporadic but still upward fashion. As covered in previous sections, RFR values are subject to both credit evaluations of the underlying government bonds as well as technical factors related to the relative availability of the underlying government bonds.

Focusing solely on the day prior and day of announced ECB rate increases, it becomes clear that both €STR and RFR react instantly to ECB policy changes. Both sets of rates provide market participants with a policy-sensitive reference rate.

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