LIBOR, apart from being one of the key benchmark rates, is tied to everything from derivatives to home and car loans. Before the global financial crisis, LIBOR was a key indicator of what banks were willing to lend to each other, and 3-month LIBOR in particular emerged as a key benchmark in the interest rate swaps market. The global financial crisis highlighted, among other things, that LIBOR is an “artificial” rate subject to ripe abuse. (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aZHPJf06Z5t8&refer=uk). LIBOR was so ripe for abuse, in fact, that many market participants wanted a reference rate set by the central banks as opposed to an average of “artificial” rates published by the dealers. As the Global Financial Crisis (GFC) dragged on (and still seems to be dragging) credit risk came sharply into focus, and the interbank market moved to zero threshold two-way CSA’s.
This has led to an interesting phenomenon as most financial institutions are currently discounting collateralized swaps using the Overnight Index Swap (OIS) curve instead of LIBOR. The line of reasoning behind this is that financial counterparties are exposed to overnight (O/N) risk to other financial counterparties instead of the risk of the full term of a particular instrument. In other words, since derivative positions (and any other positions for that matter) between financial counterparties (read banks) are fully collateralized, the only risk that each financial institution is exposed to is the risk that its counterparty cannot meet its collateral obligation the next day. In pre-GFC days, before zero threshold CSA’s were the norm, each counterparty was exposed to the full term of the exposure that each derivative and lending position presented (potential future exposure for derivatives and term risk for the tenor of a loan).
The fact that OIS discounting has surpassed LIBOR is clearly evident in the interbank market as the large European clearing firm LCH.Clearnet announced in June that it had started discounting each of its positions using OIS instead of LIBOR. LCH.Clearnet currently clears over USD $229 trillion in notional on interest rate swaps alone, and its announcement of using OIS discounting to determine valuations and subsequent margin payments was a fairly large announcement.
The fact that clearing firms in the interbank market are moving toward a different benchmark should give corporate entities some pause for thought. The reason is quite simple: Since discounting at OIS seems to have reached critical mass in the interbank market even before the OTC derivative reform is fully implemented, it is clear that the trend will only be strengthened by rules that are currently being written as OTC derivatives in the interbank market will now need to be cleared through a CCP. Given that the interbank market has already moved to OIS discounting, the next logical step will be for this trend to trickle down into the corporate sector as well.
Why, you ask?
Because those institutions that are categorized as swap dealers and “major swap participants” won’t want to post margin on one side of a position and effectively not receive margin on the corporate side. This will no doubt lead to banks effectively requiring margining through zero threshold two-way CSA’s from their corporate counterparties. Once this happens, there will no longer be credit risk in OTC derivative positions and the entire market will move to discounting at OIS and LIBOR will officially be dead.
Stay tuned for a whitepaper on this subject in the coming weeks.