“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,” said Carl Lantz, interest rate strategist at Credit Suisse in New York.
Historically, Libor has more or less tracked base rates but, as the crisis unfolded in the credit markets in the second half of last year, Libor has spiked above base rates more than other interest rate measures, such as OIS. Prior to the middle of last year, Libor and OIS had been closely correlated historically speaking, with Libor typically around 10-15 basis points above the OIS rate. However, over the past 12 months, the spread between the two rates has widened dramatically, reaching 108bp on December 4, 2007. The spread has since settled at 60-70bp. The increase in the Libor-OIS spread has prompted increased trading of OIS products, dealers claim.
Market participants observe that OIS are being used by banks to hedge themselves against central bank policy decisions and major disasters in the market.
“OIS has been one of the most de facto type hedges that you can have on against any position. For example if you want to go out and buy credit, you might want to also buy Libor-OIS spreads too, so if there is a credit event and credit spreads blow out then the chances are Libor-OIS spreads would be blown out too,” said Jim Caron, head of global rates research at Morgan Stanley in New York.
Banks' proprietary trading desks and hedge funds have also been using them to take positions on central bank policy decisions, according to Phillippe Moryoussef, head of euro overnight index average trading at RBS in London.
“They use OIS to target the specific dates the decisions take place on whether central banks will change base rates. OIS are the only type of swaps being used to target this because of their flexibility to have specific maturities on whatever date you want,” he said.
Banks and hedge funds’ increased interest in the product has led to increased notional trading volumes of OIS, according to dealers. Moryoussef estimated that the notional trading volumes of OIS have increased from approximately €100 billion three-month equivalent per day for 2005 to approximately €150 billion three-month equivalent per day for 2007.
“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 due to high volatility,” Moryoussef said.
Meanwhile, another rates banker agrees there has been an increase in notional trading volumes, which peaked in January this year, but adds that Libor products have followed the same trend. Pavan Wadhwa, head of European rates strategy at JP Morgan in London, concluded that trading in OIS has not increased relative to Libor swaps.
"OIS trading volume increased steadily in 2007 and has then fallen since the beginning of the year as risk appetite has declined. The limited market data that we have observed, however, suggests that trading volume in both OIS and Libor swaps has followed the same pattern, and the proportion of OIS to Libor swap volumes has therefore remained fairly constant," he said.
As trading volumes have increased and the OIS market has developed over the past year, there has been some improvements in liquidity for OIS products with longer maturities. According to RBS’s Moryoussef, most of the current liquidity in OIS is for the swaps up to three years, but there is now liquidity out to 10 years, which wasn't there a year ago. He claimed, for maturities between three years and 10 years, bid/offer spreads used to be 2-4 bps; this is now trading at around 1bp, mainly as a spread against the Libor swap.
However, JP Morgan’s Wadhwa does not see OIS beyond two years as liquid in comparison with Libor swaps. He cited the example of five-year OIS currently trading at a bid/offer spread of 2 – 2.5 basis points, while equivalent Libor swaps trade at a bid/offer spread of approximately 0.25 – 0.5 basis points, or roughly one-fifth to one-tenth of the OIS spread.
“This means that investors will likely choose Libor swaps over OIS for liquidity reasons," he said.
He added OIS products are popular at the moment but might not be as popular in the medium or long term. Once central banks stop changing base rates as frequently as they have done over the past year, there might not be as much demand for OIS for speculation or hedging against central bank policy decisions. "Markets have a short memory. When credit market problems subside, it is likely that interest in long-maturity OIS swaps will start to wane," he said.