On April 8, 2020, the Alternative Reference Rates Committee (ARRC) released a preliminary recommendation for calculating spread adjustments to cash products referencing USD LIBOR.^[1] The calculation methodology should provide greater clarity to market participants who are planning to implement the ARRC’s proposed fallback language as the industry transitions away from LIBOR.

Background

Spread adjustments minimize changes in value that result from replacing reference rates. In January 2020, the ARRC published a consultation^[2] on various spread-adjustment methodologies and requested that market participants express their views on which would be best suited to particular cash products. The consultation focused on floating rate notes, securitizations, business loans and consumer products.

To help market participants evaluate the proposed spread adjustments, the ARRC presented historical data and analysis to demonstrate how the potential methodologies have operated in the past. The consultation also posed questions related to (1) long-term spread levels, (2) estimated time periods to measure those levels and (3) the speed at which the adjustment should be expected to transition from the last USD LIBOR value to long-term spread levels.

The ARRC received 60 responses and extensive feedback^[3] in response to the consultation from a wide range of market participants, including consumer advocacy groups, asset managers, corporates, banks, industry associations and government-sponsored entities. After reviewing those responses, the ARRC recommended the methodology described below.

Spread-Adjustment Methodology for Cash Products

The ARRC’s recommended spread-adjustment methodology for cash products is based on a historical median over a five-year lookback period that calculates the difference between USD LIBOR and the Secured Overnight Financing Rate (SOFR). SOFR is the fallback rate that the ARRC has recommended as an alternative to USD LIBOR.^[4]

This five-year median spread adjustment methodology mirrors the methodology recommended by the International Swaps and Derivatives Association (ISDA) for derivatives which will harmonize cash products and derivatives agreements that contain similar post-LIBOR fallback language.

Moreover, the ARRC has recommended a one-year transition period to its spread-adjustment methodology for consumer products. A large number of consumer advocacy groups have endorsed this additional transition period.

Implementation

The five-year median spread-adjustment methodology targets USD LIBOR agreements that have incorporated the ARRC’s hardwired fallback language. The methodology also captures legacy USD LIBOR contracts that select SOFR as the post-LIBOR fallback rate. Because fallback language may be negotiated bilaterally, market participants would be free to implement the ARRC’s recommended spread-adjustment methodology on a voluntary basis.

Conclusion

The ARRC plans to finalize its spread adjustment recommendation in the coming weeks. The finalized recommendation will include a more detailed economic and practical overview of the five-year median methodology.

Footnotes