Libor-to-OIS Shift Challenges Buy Side

Terry Flanagan

Asset managers are facing systems challenges as banks switch over from Libor to overnight indexed swaps (OIS) for discounting their derivatives portfolios.

“For buy-side firms, implementing OIS discounting is complicated because there is no standard discounting methodology and a firm needs to reconcile methodologies across internal systems, third-party systems, and counterparty systems,” said Nosheen Khan, director in Markit’s portfolio valuations service.

An overnight indexed swap (OIS) is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index (i.e., a published interest rate which is also called Overnight Rate) over every day of the payment period.

The index is typically an interest rate considered less risky than the corresponding interbank rate (Libor).

“OIS rates are a more accurate estimate of funding costs for fully collateralised trades,” Khan said. “Before the credit crisis, the basis between Libor and OIS was negligible, and the Libor swap market was more liquid than OIS, making Libor a widely used as a proxy for funding costs. Now, because the OIS-Libor basis is significant, the market is migrating to OIS discounting in order to more accurately value OTC derivatives.”

Markit Portfolio Valuations has more than 230 clients that rely on its market knowledge and expertise to provide accurate independent valuations for their OTC derivatives.

“To help them, we provide a high level of transparency about our methodology and data inputs that they need to resolve differences and effectively engage counterparties in the case of price challenges,” Khan said.

The Bank for International Settlements estimates that at the end of 2011, $1.8 trillion of collateral was posted against counterparty credit exposures. The amount of collateral fluctuates daily with the value of the associated derivatives transactions.

Markit has enhanced its overnight indexed swap (OIS) discounting methodologies to allow for more accurate valuations of collateralized and uncollateralized trades.

The enhancements enable Markit clients to select the discounting method that matches their credit support annexes (CSAs), namely OIS, Libor, or specific dual-currency funding curves, and to match the funding curve to the tenor basis of the trade, the company said.

Markit first introduced OIS discounting to its valuations services in 2011, and the practice has since become the industry standard for calculating the margin requirements specified in CSAs, the agreements that govern collateral posted for non-cleared OTC derivatives transactions.

The International Swaps and Derivatives Association earlier this year introduced a standardized credit support annex (SCSA), based on OIS discounting, in order to accelerate the trend toward a more accurate method for pricing OTC interest-rate swaps.

The SCSA supports the move to OIS discounting by grouping derivatives into separate buckets or “silos,” based on currency. Each currency silo is evaluated independently to generate a required movement of collateral in the relevant currency.

“One of the stated objectives of ISDA’s standard CSA is to support the OIS model,” said Ted Leveroni, executive director of derivatives strategy and external relations at post-trade services provider Omgeo. “While the use of the standard CSA will remain optional between counterparties, all indications seem to point to OIS as the preferred industry discounting method going forward.”

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