Will OIS Replace LIBOR?

By Daniel Kurt | June 11, 2014 AAA
Will OIS Replace LIBOR?

For nearly three decades, the London Interbank Offered Rate, or LIBOR, has played a pivotal role in credit markets. As the interest rate to which many adjustable-rate mortgages, derivatives and forward contracts are pegged, LIBOR is designed to provide banks around the world with an accurate picture of how much it costs to borrow short term. As of Feb. 1, 2014, LIBOR is now known as ICE LIBOR.

However, a scandal that emerged in 2008 raised serious doubts about the reliability of the world’s most prominent benchmark. One of LIBOR’s potential weaknesses is that the rate comes from banks’ self-reporting, not actual market data. Each day, several of the world’s leading banks report what it would cost them to borrow from other lenders on the London interbank market. LIBOR is the average of these responses.

A Wall Street Journal investigation in the midst of the financial crisis found that LIBOR appeared much lower than other lending metrics. This suggested that banks were trying to downplay instability in the financial markets. Multiple banks – including Barclays, UBS and Royal Bank of Scotland – were later found to have rigged the key rate.

So, will the international banking community replace LIBOR with another benchmark rate, one less susceptible to manipulation? That looks like a fairly remote possibility at this point.

Perhaps the leading challenger to LIBOR is the overnight indexed swap (OIS) rate. (See also "What is the LIBOR-OIS Spread and what is it used for?") OIS is typically tied to a given country’s central bank rate – i.e. the Fed funds rate in the U.S. – so it’s theoretically less prone to manipulation. There has already been a marked shift toward OIS for certain derivative transactions. Further, important voices have been calling for LIBOR’s wholesale replacement. Among them is Gary Gensler, chairman of the Commodity Futures Trading Commission.

However, most efforts to date have been moves to reform, rather than replace, the benchmark. In 2012, International Organization of Securities Commissions established a task force to come up with recommendations. Among its proposals: moving LIBOR oversight away from the British Bankers Association and requiring banks to back their responses with actual market data.

The Bottom Line

Ultimately, it’s up to regulators in individual countries to decide on LIBOR’s future. But for now, the ubiquitous rate looks surprisingly resilient.

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