What Is the LIBOR-OIS Spread and Why Does It Matter?

A decade ago, most traders didn’t pay much attention to the difference between two important interest rates—the London Interbank Offered Rate (LIBOR) and the Overnight Indexed Swap (OIS) rate. That’s because, until 2008, the gap, or “spread,” between the two was minimal. But when LIBOR briefly skyrocketed in relation to OIS during the financial crisis beginning in 2007, the financial sector took note.

The LIBOR-OIS spread was considered a key measure of credit risk within the banking sector.

To appreciate why the variation in these two rates mattered, it’s important to understand how they differed.

Important

The Intercontinental Exchange, the authority responsible for LIBOR, ceased publishing one-week and two-month USD LIBOR after Dec. 31, 2021. All other LIBOR were scheduled to be discontinued after June 30, 2023. The United Kingdom Financial Conduct Authority required continued publishing of “synthetic” USD LIBOR until Sept. 30, 2024, to aid in transition.

Defining the Two Rates

LIBOR

LIBOR (officially known as ICE LIBOR since February 2014) was the average interest rate that banks charged each other for short-term, unsecured loans. The rates for different lending durations—from overnight to one year—were published daily. The interest charges on many mortgages, student loans, credit cards, and other financial products were tied to one of these LIBOR rates.

LIBOR was designed to provide banks around the world with an accurate picture of how much it cost to borrow short term. Each day, several of the world’s leading banks reported what it would cost them to borrow from other lenders on the London interbank market. LIBOR was the average of these responses.

OIS

The OIS, meanwhile, represents a given country’s central bank rate throughout a certain period; in the US, that’s the Fed funds rate—the key interest rate controlled by the Federal Reserve, commonly called “the Fed.” If a commercial bank or a corporation wants to convert from variable interest to fixed interest payments—or vice versa—it could “swap” interest obligations with a counterparty. For example, a U.S. entity may decide to exchange a floating rate, the Fed Funds Effective Rate, for a fixed one, the OIS rate. There’s been a marked shift toward OIS for certain derivative transactions.

Because the parties in a basic interest rate swap don’t exchange principal, but rather the difference of the two interest streams, credit risk isn’t a major factor in determining the OIS rate. During normal economic times, it wasn’t a major influence on LIBOR, either. But that dynamic changed during times of turmoil, when different lenders began to worry about each other’s solvency.

The Spread

Before the subprime mortgage crisis in 2007 and 2008, the spread between the two rates was as little as 0.1 percentage points. At the height of the crisis, the gap jumped as high as 3.65 percentage points.

The following chart shows the LIBOR-OIS spread before and during the financial collapse. The gap widened for all LIBOR rates during the crisis, but even more so for longer-term rates.

The Bottom Line

The LIBOR-OIS spread represented the difference between an interest rate with some credit risk built in and one that was virtually free of such hazards. Therefore, when the gap widened, it was a good sign that the financial sector was on edge.