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

Before 2008, 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 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 until LIBOR was phased out.

To appreciate why the variation between lending rates and swap rates mattered, it’s important to understand how they differed.

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.

Secured Overnight Financing Rate (SOFR)

Following the rate-rigging scandal, LIBOR was criticized because it was based on self-reported rates from bank officials, rather than the actual rates negotiated between banks. This allowed bankers to manipulate the reference rate in their favor by reporting artificially higher or lower rates.

In order to resolve these issues, the Federal Reserve established the Alternative Reference Rates Committee (ARRC), to transition towards a new reference rate less susceptible to manipulation. In 2017, the committee recommended replacing LIBOR with the Secured Overnight Financing Rate (SOFR) as the benchmark reference rate for overnight loans. LIBOR was slowly phased out, and the last USD LIBOR rates ceased publication in 2023.

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. A large spread indicated that the banking sector had a high degree of risk, while a low spread suggested a lower degree of risk.