Talk Again For Libor Alternatives

A few months ago there was a discussion regarding the problems with Libor, in particular, how many banks may have been under-reporting their actual cost of borrowing. At the time there was speculation that a new way was necessary to insure that the rates quoted actually represented the true cost of borrowing. A recent article in the Financial News discusses how swap traders are once again beginning to show interest in alternatives to Libor.

Potential alternatives include the Sonia (Sterling overnight index average) and Eonia (Euro overnight index average). While Libor is calculated each day as an average of what banks state (think) are their borrowing costs, the Sonia and Eonia are effective rates computed as a weighted average of overnight unsecured lending in the interbank market. The Eonia is one of the benchmarks for the euro zone money and capital markets and is the standard interest rate for Euro currency deposits. The European Central Bank calculates the Eonia daily.

Most interest rate swaps have short maturities under two years, but more than one day. Swaps pegged against an overnight fixing are known as an Overnight Indexed Swap (OIS). This overnight market is a small part of the overall interest rate market, but interest in the market is increasing as traders look for alternatives to Libor. Numerous traders, from FX traders, hedge funds, mortgage lenders, and asset swap traders are showing interest for two curves, one against Libor for longer-term swaps, and one for overnight fixings.

Even with its problems, it is probably too early to write-off the Libor rate, as highlighted in a recent Reuters article (posted on Forbes.com). Many feel that the Libor system is not broken, but that recent volatility can be blamed on the reluctance among member banks to lend to each other as a result of the on-going credit crunch. The number of assets pegged to Libor is too large to make a quick transition. It is more likely that further steps will be taken instead to insure that banks are reporting the correct borrowing rates.