Libor Proxies Gain as Traders Seek Truth With Overnight Swaps
By Liz Capo McCormick
May 29 (Bloomberg) -- Traders are starting to use alternative measures for borrowing costs as the British Bankers' Association struggles to keep the London interbank offered rate as the global standard.
Libor, the benchmark for 6 million U.S. mortgages and more than $350 trillion of derivatives and corporate bonds, has been called into question since the Bank for International Settlements said in March some lenders may have understated borrowing costs to keep from appearing like they are in financial straights.
One option growing in popularity is overnight indexed swaps, a gauge of expectations for central bank rates. The Federal Reserve uses the one-month OIS rate to set the minimum bid level when it lends cash to banks through its Term Auction Facility. The Fed has auction $510 billion through the TAF since December.
``The OIS rate is something I look at a lot more closely than I used to,'' said Nish Popat, head of fixed income in Dubai at Emirates NBD PJSC, the Persian Gulf's biggest bank by assets. ``It gives you a better idea of where the lending and borrowing level between banks is and it's a market-traded price.''
Libor was thrust into the spotlight in August when global borrowing costs rose as the U.S. subprime-mortgage market collapsed. The BBA said April 16 it would speed up an annual review of the 24-year old system and threatened to ban member banks found misquoting rates. It's scheduled to publish the findings of the review tomorrow.
Libor Proxy
Libor is set once a day by the BBA, which publishes the rate after asking 16 member banks how much it would cost to borrow from each other in a range of currencies. The three-month dollar OIS rate fluctuates through the day.
Overnight indexed swaps are over-the-counter traded derivatives in which one party agrees to pay a fixed rate in exchange for the average of a floating central-bank rate over the life of the swap. For dollar swaps, the floating rate is the daily effective federal funds rate.
``OIS rates have the advantage that they are set off the fed funds effective rate, which is an overnight rate based on a volume-weighted average of trades that occur each trading day through the major brokers,'' Eric Liverance, head of derivatives strategy at UBS Securities LLC in Stamford, Connecticut, wrote in report dated May 27. ``There is no guesswork involved.''
Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events, such as changes in the weather.
Rate Proxy
OIS rates can be used as a proxy for interest-rate expectations and tend to be lower than Libor ``under normal market conditions,'' the Basel, Switzerland-based BIS said in its March report.
The three-month dollar OIS rate was 1.994 percent yesterday, while three-month dollar Libor was 2.65 percent, a difference of 66 basis points. The spread averaged 11 basis points in the 10 years prior to August, before widening to as much as 106 basis points on Dec. 4. A basis point is 0.01 percentage point.
Trading in fed fund futures surged 55 percent in April from the prior month to an average of about 98,000 contracts a day, while transactions in Eurodollars, which are priced off Libor, slid 7.5 percent to an average 2.6 million contracts, according to CME Group data. Futures are agreements to buy or sell assets at a set date and price.
``There is an interest rate being charged in the market and people need to know what that rate is,'' said Michael Gorham, former director of the U.S. Commodity Futures Trading Commission and head of the IIT Stuart Center for Financial Markets at the Illinois Institute of Technology in Chicago. ``Swaps and all kinds of other things like mortgages and credit cards are referenced to Libor.''
`Baked Into System'
The chance that OIS rates, which aren't used like Libor as a peg for contracts and other agreements, will emerge as a viable alternative benchmark is low, according to Liverance. Central banks may be wary of OIS rates taking root because trillions of dollars of derivatives would get tied to their rates, he wrote.
``If Libor can get through this with fairly limited changes and remain the interest-rate benchmark, it will have survived a strong test,'' said William Porter, European credit strategist at Credit Suisse in London. ``But one likely result is people are going to start using some of the alternative benchmarks.''
NYSE Euronext's Liffe derivatives market said this month it will offer futures based on Sonia and Eonia, the sterling and euro overnight interbank averages. ICAP Plc, the biggest broker of transactions between banks, is testing the so-called New York Funding Rate, based on an anonymous daily survey of at least 24 banks, according to Lou Crandall, chief economist at ICAP's New York research unit.
Libor ``tells a very complicated story,'' said Padhraic Garvey, head of investment-grade debt strategy at ING Bank NV in Amsterdam, a unit of the biggest Dutch financial-services company. ``If it's making calls on the market and trying to access where expectations are, then it's the OIS rates that I'd look at.''
To contact the reporter on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net
Last Updated: May 28, 2008 21:31 EDT |
