On 21 July 2021, the U.S. Alternative Reference Rates Committee (“ARRC”) announced the publication of conventions and use cases for employing Term SOFR, as produced by CME Group, in transitioning loan products away from LIBOR. Although the ARRC has not yet recommended the use of Term SOFR, it published these new resources in anticipation of announcing shortly a formal recommendation for the use of Term SOFR “across financial markets.”
While generally helpful to support a smooth transition, the ARRC noted that Term SOFR will be especially helpful in the business loans market, particularly multi-lender facilities, middle market loans, and trade finance facilities, as well as in limited cases of hedges and securitizations tied to term rates.
The Forward Looking Term SOFR and SOFR Averages (Applied in Advance) Conventions for Syndicated and Bilateral Business Loans (the “Forward Conventions”) apply to both new and legacy loans using in-advance rates, and supplement the in-arrears conventions published by the ARRC in 2020. The different reference sources, day-count conventions, and publication calendars for Term SOFR and SOFR Averages are explained, and recommendations are given regarding key loan conventions. The Forward Conventions include: temporary rate unavailability, holiday and weekend conventions, lookbacks, borrowing notice and interest periods, daycounts, floors, rounding, and compensation for losses. The continuing importance of robust fallback language is emphasized. Spread adjustments for transitioning legacy loans also are discussed.
The companion ARRC Best Practice Recommendations Related to Scope of Use of the Term Rate (the “Use Cases”) are intended to be in line with the Key Principles for recommending a forward-looking term rate that the ARRC announced in April 2021. The Use Cases highlight that the use of Term SOFR “be proportionate to the base of transactions underlying” the rate. They include an acknowledgement that the fallback provisions in legacy contracts that adopted the ARRC’s recommendations all will fall back to Term SOFR, as is expected to the be case for contracts covered by the New York legislative solution (and we note that Alabama has adopted a similar statute and federal legislation is pending), which effects a transition to the rate recommended by the ARRC/Federal Reserve.
In the case of new contracts, the Use Cases acknowledge that the use of overnight and in arrears average SOFR “has proven to be difficult” for some products, and states that the use of Term SOFR is supported by the ARRC for business loans and securitizations that hold term rate-linked assets. However, the Use Cases also state clearly that the use of Term SOFR is not supported for the “vast majority” of derivatives transactions that already reference SOFR compounded in arrears, the market depth of which is “essential to the construction of the SOFR Term Rate over time.”
At its fourth SOFR Symposium on 21 July 2021, the ARRC discussed the Conventions and Use Cases in greater detail and emphasized the key role that the Commodity Futures Trading Commission’s “SOFR First” Transition Initiative—a transition of interdealer swap trading conventions from LIBOR to SOFR that will begin on 26 July 2021—will play in building SOFR liquidity and a deep SOFR market that can support Term SOFR. The ARRC indicated that the successful implementation of “SOFR First” will be a critical component in satisfying its Key Principles and permitting a formal recommendation for the use of Term SOFR. A formal recommendation on Term SOFR, in turn, will be critical to legacy transactions that use the ARRC’s recommended fallback language or can be expected to rely on legislative solutions, as noted in the Use Cases.
With respect to new originations, Term SOFR also is important to segments of the cash market where the applicable interest rate and related payment obligation need to be known up front, including business loans and trade finance. Loans in particular (and products, such as Collateralized Loan Obligations, that incorporate those loans) face complexities relating to revolving credit activity, loan trading, and prepayments that are more easily accommodated with a forward-looking term rate. The Symposium panel also noted that Term SOFR and advance SOFR Averages can benefit smaller market participants by providing less complex choices that can work for them operationally.
The Symposium closed by reiterating that 26 July 2021 represents a very important “collective deliverable” that will enable the availability of Term SOFR to the parts of the market that need it to complete a smooth transition away from LIBOR. The ARRC has stated that the proposed changes to interdealer trading conventions effected by the “SOFR First” initiative would satisfy the Key Principle relating to “visible progress to deepen SOFR-linked derivatives liquidity.” As a result, the ARRC has indicated that the successful implementation of “SOFR First” should allow the ARRC to formally recommend Term SOFR shortly after 26 July 2021.