Will OIS be the successor to LIBOR? Lets take a look at the similarities and the differences.
An OIS exchanges a fixed rate for a floating overnight Fed Funds rate geometric average. The rate reflects expectations for Fed Funds over the term of the trade. As a cleared swap, there isn’t an exchange of notional, only IM and VM and a final cash settlement based on the differences between the rates.
LIBOR also reflects interest rate expectations over the term of the trade. Except there is an initial exchange of notional – the cash is actually lent – and there is no mark-to-market on the transaction during the loan. There is counterparty risk in an inter-bank loan that is mitigated on an OIS trade (by running the trade through a CCP).
From the point of view of a financing, a bank trader looking to raise money might borrow cash via a LIBOR-based loan OR put together a combination of an OIS trade for the same term (paying fixed, receiving floating Fed Funds effective) plus borrowing cash in the overnight Fed Funds market. On the OIS, the two Fed Funds legs cancel each other out (more or less), leaving a fixed rate borrowing.
But if the cash flows look the same (on a net basis) and each reflects a fundamental interest rate expectation component, why have the two not always yielded the same results?
If a trader borrows at 6 month LIBOR, come hell or high water they have the cash. Their obligation is simple: to return the money at the end of the trade plus interest. If a trader enters into an OIS trade, they have a different risk. Should the Fed Funds market be disrupted – either because of some sort of systemic problem or idiosyncratic issue with the borrowing bank, they are short cash. In the financial crisis when LIBOR/OIS spiked, it reflected the price banks had to pay to lock in the cash versus rolling the dice each day on Fed Funds. Regulators have often criticized banks for running funding mismatches – borrowing short, lending long – but isn’t that what is happening with a OIS + Fund Funds borrowing?
On earlier occasions we have gone into the other issues with OIS – for technical reasons Fed Funds is an impaired rated due to IOER, etc. etc. That still holds true. But the fundamental differences between OIS and LIBOR show that the risks don’t line up. One is not simply a synthetic version of the other. It is hard to advocate for the market to veer toward OIS as a substitute for LIBOR.
OIS levels can and do inform us about short-term rates in general and LIBOR levels in particular. And OIS levels and volume are more transparent than LIBOR (at least until the LIBOR trade repository is done). But it is still apples to oranges.