Libor disruption spurs OIS growth


Dislocation in Libor rates in the wake of the credit crisis has spurred increased trading in overnight index swaps (OIS) over the past year. Dealers say greater activity by banks, as well as hedge funds, has been behind the rise in volumes.

Confidence in the Libor fixings has been undermined in recent months as the spread between Libor and OIS rates has leapt to record highs. Having historically fixed at around 12 basis points over the OIS rate, the spread between the two began to rise last August, peaking at 108bp on December 4. It has since stabilised at around 60-70bp.

The widening spreads reflect greater perceived risk in interbank lending, as dealers continue to report multi-billion-dollar losses on subprime mortgage exposures. With banks unwilling to lend to each other, Libor has become more a measure of counterparty credit and liquidity risk, say dealers. Nonetheless, some participants have claimed Libor still underestimate the rates at which banks can borrow, with rumours circulating in the market earlier this year that banks were purposely misreporting their lending rates to the British Bankers' Association (Risk June 2008, pages 73-751).

"Increased interest in OIS products started around August 8 last year, at the start of the credit crisis, and the Libor-OIS spread started to widen," says Carl Lantz, interest rate strategist at Credit Suisse in New York.

This lack of confidence with Libor fixings has prompted a broader spectrum of participants, including hedge funds, to trade OIS as an interest rate benchmark. "Banks and hedge funds use OIS to target the dates when central banks make decisions on whether to change base rates," explains Philippe Moryoussef, head of euro overnight index average trading at Royal Bank of Scotland in London. "OIS is the only type of swap being used to target this because of its flexibility to have specific maturities on whatever date you want."

Moryoussef estimates the notional trading volumes of OIS products have increased from approximately EUR100 billion three-month equivalent a day in 2005 to EUR150 billion three-month equivalent a day in 2007. "However, I would estimate for the first six months of 2008, the notional trading volumes have decreased a bit, not because of a lack of interest but mainly because of illiquidity caused by high volatility," Moryoussef adds.

Other dealers agree that interest in OIS has risen sharply over the past 12 months. According to Barclays Capital, OIS sterling trading volumes surged 70% in the first half of this year compared with the corresponding period of 2007. In the second quarter of 2008, Barclays Capital traded a higher notional amount of sterling OIS than sterling Libor swaps - the first quarter this has happened. However, the average maturity of OIS trades is significantly shorter than Libor swap trades.

That is changing. Dealers report a steady lengthening of the OIS curve in recent months to as long as 10 years. "Euro OIS trading has generally changed from being dominated by meeting date OIS (one-month maturities) towards longer-dated OIS contracts, including five- and 10-year swaps," says Nat Tyce, head of sterling and Scandinavian rates trading at Barclays Capital in London.

Bid/offer spreads for longer-dated OIS trades have contracted, but still remain wider than their Libor equivalents. Five-year OIS currently trade with a bid/offer spread of between 2-2.5bp, while the bid/offer spread for five-year Libor swaps is approximately 0.25-0.5bp, notes Pavan Wadhwa, head of European rates strategy at JP Morgan in London "This means that investors are likely to choose Libor swaps over OIS for liquidity reasons," he adds.

Wadhwa expresses doubts over the longer-term popularity of OIS products. Once the fallout from the credit crisis settles, traders will once again prefer using Libor as the key interest rate benchmark, he says. "Markets have a short memory. When credit market problems subside, it is likely that interest in long-dated OIS swaps will start to wane."

Others disagree. While most are sceptical OIS will fully replace Libor as the primary reference rate for swaps and structured products, some believe OIS trading volumes will remain at a higher level than they were before the credit crunch. "The longer-term OIS would be used mainly by banks that have exposure to Libor/OIS basis risk, and hedge funds and real money investors that would use them for interest rate overlay strategies," adds Tyce.



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