In September 2019, the Loan Market Association published exposure drafts of Compounded Risk Free Rate Facility Agreements by reference to SONIA and SOFR, being the chosen replacement near risk free rates for LIBOR in the Sterling and USD markets respectively together with commentary inviting market participants to consider various structuring issues which need to be considered if adapting them for use in live transactions (see earlier blog). By way of follow up, on 20 February 2020 the LMA published a note on the outstanding points to be dealt with before the Exposure Drafts can be published as recommended form documentation for use in new loan transactions with interest referenced to risk-free rates. The key points identified are:
(i) Formula for calculating the Fallback Compounded Rate: the LMA notes that whilst formulae were set out in the Financial Stability Board publication entitled “Overnight Risk-Free Rates – A User’s Guide” in June 2019, these do not seem to work well for the syndicated loan market in terms of managing events taking place intra-interest period (such as prepayments or secondary trading).
(ii) Agreement on key conventions for compounding risk-free rate, in particular:
(A) whether to compound the rate (whereby the interest amount is calculated daily by compounding the daily published RFR and applying the compounded rate to the principal) or compound the balance (whereby the interest is calculated daily on the outstanding principal plus accumulated unpaid interest balance); and
(B) the use or not of an observation shift, which impacts the weighting of days in the reference period.
(iii) Availability of a screen rate / index / calculation service: The LMA notes there is currently no screen rate to reference as yet and that discussions in the different currency working groups are now focusing on the use of a daily compounded risk-free rate index. In the US, the Federal Reserve Bank of New York has announced that it will publish a SOFR Index from 2 March 2020 but there have not been similar announcements in relation to other currencies which the risk-free rate exposure draft facility agreements can reference. Until that time, as drafted, the exposure drafts apply the Fallback Compounded Rate which would need to be calculated by facility agents on the basis of an agreed calculation methodology.
The LMA notes that although there is work ongoing in the various different currency working groups on these issues, there is as yet no consensus and encourages market participants to contribute comments and feedback from pilot transactions testing the issues.
The LMA invites feedback from market participants to be addressed to lma@lma.eu.com.