Recently, the Alternative Reference Rates Committee (ARRC) announced its formal recommendation of the CME Group's (formerly known as Chicago Mercantile Exchange i.e. the world's largest derivative exchange) forward-looking Secured Overnight Financing Rate (SOFR) term rates. As the publication of LIBOR is not guaranteed beyond 2021, with less than five months remaining until the deadline, the ARRC's formal recommendation of SOFR Term Rates is a much-awaited breakthrough that provides a transition mechanism, first envisaged in 2017. This event marks a major milestone as it provides one of the first solutions (in respect of the dollar denominated financial transactions) to the dreaded disruption looming in the face of expiring LIBOR rates and the consequent volatility in financial markets.
The adoption of SOFR Term Rate marks the completion of the 'Paced Transition Plan' developed by the ARRC. The ARRC had also published a set of key transition milestones that market participants were encouraged to achieve across floating rate notes, business loans, consumer loans, securitisations and derivatives. These included:
- New USD LIBOR cash products to include ARRC recommended, or substantially similar fall-back language.
- Third party technology and operation vendors to complete all necessary enhancements to support SOFR.
- Third party technology and operation vendors to complete all necessary enhancements to support SOFR.
- Third party technology and operation vendors to complete all necessary enhancements to support SOFR.
Understanding SOFR
SOFR is a backward-looking rate, based on the cost of borrowing cash overnight collateralised by the US Treasury securities in the repurchase agreement market. As it is a backward-looking rate, it can only be published in retrospect. For example, the rate applicable is made available on the following day. The rate is published by the New York Fed in cooperation with the Office of Financial Research each day by or before 8:00 a.m Eastern time.
Compared to LIBOR, the SOFR is recognised as a more resilient rate due to the underlying market depth that it is based upon. It is estimated by the New York Fed that the transaction volumes underlying SOFR are approximately USD 1 trillion in daily volumes – which is far greater than the transactions in any other US money market. This determination mechanism of the SOFR not only makes it more stable and transparent, but also makes it less vulnerable to manipulation.
The SOFR Term Rate, on the other hand, is a forward-looking rate that is calculated on the transactions in the derivatives market. In simpler terms, the forward-looking SOFR Term Rate denotes the derivative market's predictions for the interest rate rather than the prior day's overnight performance. This speculative rate checks largely in line with the actual changes in the market's interest rates due to sheer depth of the market it is based upon.
Challenges posed by backward-looking rates
Over the past few decades, the loan markets have relied on forward-looking LIBOR reference rates, where benchmark interest rates have been known at the beginning of each interest period. For the market to adjust to a backward-looking rate, owing to the LIBOR transition, poses the risk of uncertainty and computational hassles. To apply a backward-looking rate towards an interest period means applying the overnight interest rate each day. While certain measures have been devised to mitigate the hassle, for example, the application of a 5-business day lookback period, this application of the interest rate is neither ideal or convenient.
Even in the case of such mitigating measures, the calculation of compounded interest rates remains challenging. As borrowers, in practice, do not pay an interest amount every day, the accumulated interest itself accrues interest. This non-cumulative compounding interest methodology is complex, and presents operational challenges to both lenders and borrowers. Additionally, in the case of LMA/APLMA documentation, this makes for approximately 30 pages of complicated mathematical calculations. The use of the forward-looking rate for the USD dominated transactions would make the switch a lot easier.
In addition, for transactions that are structured on the tenets of Islamic finance, backward-looking rates become rather problematic. While the use of forward-looking rates has been in line with Sharia law principles, as it enabled the rate to be calculated at the start of the contract, the backward-looking rates pose a challenge. Sharia law strictly prohibits any form of speculating or gambling, which is called 'maisir'. Therefore, Islamic banks and financial institutions are prohibited from involvement in contracts where the transactions depend on an uncertain event in the future. The rules of Islamic finance also ban participation in contracts with excessive risk or uncertainty. This is to say, that the rules of Islamic finance endorse contracts with near complete certainty on day one. The challenge is that backward-looking rates mean overnight rates are compounded in arrears, so a borrower does not know for certain what profit payment amount is to be paid until shortly before the end of the period. This lack of visibility results in a lack of certainty on the terms of the financial product, violating the Sharia principle of 'gharar' (uncertainty).
In the face of such challenges with the backward-looking rate, the advent of SOFR Term Rate is much awaited and welcomed to avoid computational and procedural hassles, and to resolve the conflicts with the jurisprudence of Islamic finance.
ARRC's recommended loan conventions for Term SOFR
With the different forms of SOFR rates in place i.e. the 'Daily Simple SOFR in Arrears', 'Daily Compounded SOFR in Arrears', 'SOFR Term Rates', and 'SOFR Averages (Applied in Advance)', ARRC has published its recommended conventions for both new loans that use SOFR, and for legacy loans that fall back from LIBOR to SOFR upon the cessation of LIBOR. It is noted that these conventions may not be applicable to all forms of business loan markets, and are applied on a case-by-case basis:
(a) Rate publication: calendars referenced in documentation align the definition of business days with "US Government Securities Business Days" or "USGS Business Days" i.e. any day except for a Saturday, Sunday or a day on which the Securities Industry and Financial Markets Association recommends that the fixed income departments of its members be closed for the entire day for purposes of trading in US government securities. A version of this definition is adapted in the US denominated transactions outside of the US, and similarly is adapted for the international transactions.
(b) Fall-back provision for temporary unavailability of rate: for the remote events where the SOFR Term Rate is not published temporarily, a fall-back provision be inserted for the adoption of a rate published by the relevant administrator for the first preceding USGS Business Day, as long as the rate is not more than three USGS Business Days prior to that day. Alternatively, some parties may elect to use interpolation, depending on the operational capabilities of the finance parties.
(c) Lookback: to use the rates published two USGS Business Days prior to the first day of the interest period and held for the entirety of the interest period, similar to the LIBOR conventions.
(d) Borrowing notice period: borrower to provide notice of borrowing request three USGS Business Days prior to the borrowing date, similar to the LIBOR conventions.
(e) Length of interest period may not be equal to SOFR Term Rate: as SOFR Term Rates are published as one-month, three-month and six-month forward-looking term rates, for interest periods that do not match these durations, parties may use the next closest rate or interpolate between rates.
(f) Day-counts: parties may use actual/360 days, as is the standard in US money markets.
(g) Modified Following Business Day: payments scheduled on a non-business day may be adjusted to the next succeeding business day, unless that business day falls in the next succeeding month, in which case, the interest payment date can be the preceding business day.
(h) Compensation for losses: parties may consider inclusion of language in agreements that compensate lenders for funding losses, for example, failure to make borrowings or payments when scheduled.
(i) Interest rate floors: parties may consider applying interest rate floors.
(j) Rounding: SOFR Term Rates, akin to LIBOR, are published to five decimal places and dollar amounts may be calculated to two decimal places; parties may consider using their current rounding practices.
(k) Fall-back language: loan documentation may include comprehensive and practical fall-back language.
The definitions would need to be amended for the use in the cross border or non-US agreements but this is achievable by some amendments to the current version of the Loan Market Association documentation.
ARRC's recommended practices for use of SOFR Term Rates
In the case of legacy transactions, for floating rate notes, bilateral and syndicated business loans and securitisation transactions, the ARRC recommends that the SOFR Term Rates at the top of the fall-back cascade. Therefore, in the case of legacy contracts, which have incorporated the ARRC's fall-back language without modification, will fall-back to SOFR Term Rates at the expiration of LIBOR. In the case of new transactions, the ARRC recommends the use of the backward-looking overnight SOFR rates, but considering its' challenges, the ARRC also supports the use of SOFR Term Rates for business loans, syndicated facilities, middle market loans and trade finance loans. It is also worth mentioning that the ARRC does not support the use of SOFR Term Rates for the derivatives market, as these markets function on backward-looking SOFR compounded in arrears.
How DWF can support you
It is expected that the shift away from LIBOR to other benchmark rates will require more than USD 200 million in trades and loans to move to new benchmarks, with SOFR expected to take the majority of the volume.
With the fast approaching expiration of LIBOR rates, the variations in secured overnight financing rates and imminent revisions across loan documentation, borrowers, and lenders will need legal representation to usher them through the legal formalities.
We offer one-stop, cost-effective, efficient and streamlined solution to LIBOR transition:
- Transactional lawyers that understand and can draft and negotiate amendments in myriad types of documentation (conventional and Islamic finance, derivatives and capital markets).
- AI led and human controlled solution that can be used to analyse hundreds of non-complex financing and derivative documents to identify and update the language, and integrate it with human quality checks to help financial institutions and in-house lawyers.
- Negotiate and draft bespoke agreements on complex transaction documentation.
- Assist in any disputes arising from LIBOR transition.
Countdown to LIBOR: Frequently asked questions
