The secret history of the OIS discounting bonanza

The Wild West


The fact that swaps traders at Goldman Sachs and a handful of other dealers made a lot of money in 2008 and 2009 as a result of the industry’s switch to collateral-based valuation is an open secret. Exactly how they did it, and how much they made, has never previously been revealed.

Thanks to a host of interviews with current and former traders on the buy- and sell-side, this month’s cover story sheds some light on what was arguably the most dramatic change in the history of the over-the-counter derivatives market, during a time when the financial system itself was coming apart at the seams.

“It had a Wild West-type feel, and it was breaking new ground,” one swaps trader says. “With hindsight, they were fantastic times. I learned more in those two years than in the previous 10 years of my career.”

What everyone learned was that trades should be discounted at the rate paid on the accompanying collateral – the overnight indexed swap (OIS) rate for cash-collateralised trades – and that swaps portfolios across the Street were valued incorrectly. What made it interesting was that everyone learned this at different times, with Goldman Sachs a couple of years or more ahead of the pack.

It meant Goldman could pre-position its books to benefit – the switch to OIS from Libor meant the value of derivatives assets and liabilities would grow, so the bank tried to boost the former and constrain the latter. From what little public information is available, that seems to have been hugely successful. In 2008, the bank’s annual report shows it received $137 billion in cash collateral – a 132% increase on the previous year – while the amount of cash it posted grew only 22%.

With hindsight, they were fantastic times. I learned more in those two years than in the previous 10 years of my career

It also meant the bank had more time to comb through its collateral agreements and amend them so counterparties – when they woke up to the new pricing orthodoxy – would not be able to take advantage. A former Goldman trader says the bank had a team of 10 lawyers devoted full-time to the task. Other banks soon started to use the same tactics.

We don’t know exactly how much Goldman Sachs made as a result, but traders at other banks claim to have earned up to $600 million over a three-year period specifically from OIS-driven trades and they are convinced Goldman made more – possibly as much as $1 billion.

That is an extraordinary sum to extract from the minutiae of credit support annexes, and it explains why one of the traders that agreed to speak – reluctantly – only did so out of a sense of historic duty: “Before all of this gets completely lost in the myth-making that follows this kind of stuff, someone should sit and write it all down.”

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