Euro Short-Term Rate (ESTR) definition

What is the ESTR interest rate benchmark?

The Euro Short-Term Rate (ESTR) is an interest rate benchmark that reflects the overnight borrowing costs of banks within the eurozone. The rate is calculated and published by the European Central Bank (ECB).

The ESTR is replacing the previous euro overnight index average (EONIA) and euro interbank offered rate (EURIBOR) to become the benchmark for the European Union (EU) and European Free Trade Association (EFTA). This is because EURIBOR and EONIA failed to meet the requirements set out in the EU’s new benchmark regulations, which states that all interbank rates must be based on data rather than estimates and surveys.

How does the ESTR work?

The ESTR works by using the transaction data collected as part of the daily reporting on monetary exchanges from the 52 largest eurozone banks. It represents the average interest rate attached to loans throughout a business day.

Each day the ESTR rate is based on the transactions that are settled on the previous business day. For example, the index’s initial rate on 2 October 2019 is the data for the trading activity that happened on 1 October 2019.

The rate will be published by the ECB, using algorithms that will prevent the rate being impacted by anomalous trades and patterns.

ESTR vs LIBOR

The London interbank offered rate (LIBOR) is the average of 35 different benchmark interest rates that cover five major currencies – the US dollar, euro, British pound, Japanese yen and Swiss franc.

Unlike ESTR and other newer benchmarks, LIBOR is not transaction based, but is taken from a survey. It asks banks at what rate they would borrow money at a specific time – the 25% highest and lowest rates are dismissed, and the ‘middle’ rates are used to calculate the average.

The rate was used to secure financial contracts globally. However, LIBOR started to decline in use following the scandal in 2012, in which major financial institutions manipulated the LIBOR rate. This increased the demand for a transaction-based system and led to the creation of replacement indices. For example, the selected alternative rate in the US is the secured overnight financing rate (SOFR), and the new rate in the UK is the reformed sterling overnight index average (SONIA).

What is a good or bad gearing ratio?

A good or bad gearing ratio is completely relative, as it is a comparison between an individual company and other companies in the same industry. However, there are some basic guidelines that can be used to identify desirable and undesirable ratios:

• A high gearing ratio is anything above 50%
• A low gearing ratio is anything below 25%
• An optimal gearing ratio is anything between 25% and 50%

A company with a high gearing ratio will tend to use loans to pay for operational costs, which means that it could be exposed to increased risk during economic downturns or interest rate increases. This could lead to financial difficulties, and even bankruptcy.

A company with a low gearing ratio will generally have more conservative spending habits or operate in a cyclical industry – one that is more sensitive to economic ups and downs – so it tries to keep its debts down. Companies with low gearing ratios maintain this by using shareholders’ equity to pay for major costs.

Pros and cons of ESTR

Pros of ESTR

ESTR is calculated more transparently than LIBOR as it is based on regulated and secured data. Instead of answering a question, banks will have to send proof of their eligible trades. The data will be completely regulated by the EU’s Money Market Statistical Reporting Regulations, to provide financial stability and be less susceptible to manipulation.

Compared to the previous benchmarks, ESTR will include a larger number of parties, which means that there will be more transaction data and more accuracy in the interbank rate. The ESTR will also be more representative of rates in the markets.

Cons of ESTR

While the rates are being swapped over, there is a valuation risk. EONIA rates were significantly higher than ESTR, so some contracts might see a difference in the rates they are given. However, it is likely that in order to standardise the process, all borrowing contracts will adopt the new interest rates.