On July 29, the Alternative Reference Rates Committee (ARRC) formally recommended the use of the CME Group's forward-looking Secured Overnight Financing Rate (SOFR) term rates (Term SOFR) as a replacement to the London Interbank Offered Rate (LIBOR). This announcement resulted from the Market Risk Advisory Committee (MRAC) of the Commodity Futures Trading Commission's (CFTC) formal adoption of the SOFR First convention, which took place on July 26. This marks the latest step in the move away from LIBOR, which expires on December 31.
This change did not come as a surprise as it was preceded by years of incremental steps ARRC outlined as necessary before it would make a formal recommendation for SOFR to replace LIBOR. However, the importance should not be understated since it represents a major step toward securing the future of SOFR-based term rates, making them widely available as a LIBOR alternative going forward. Like LIBOR, the CME Term SOFR is a forward-looking rate that can be set for 30, 90, or 180 days, which brings greater certainty to the borrower and easier interest calculations for the lender compared to simple SOFR, which is calculated in arrears. It is, in short, the SOFR-based LIBOR replacement for which the banking markets have been waiting.
In 2017, ARRC published its "Paced Transition Plan," which provided a timeline and specific steps to aid in the adoption of SOFR. The fifth step required the "[c]reation of a term reference rate based on SOFR derivatives markets once liquidity has developed sufficiently to produce a robust rate." With MRAC' decision to adopt the SOFR First convention, ARRC formally recommended the CME Term SOFR and completed the Paced Transition Plan.
The MRAC-recommended SOFR First initiative has four phases. Completed on July 26, the first phase involves where brokers would start trading with SOFR linear swaps as opposed to LIBOR swaps on the interdealer market. There are three subsequent phases of the SOFR First initiative, including cross-currency swaps, nonlinear derivatives, and exchange-traded derivatives. In each instance, SOFR would replace LIBOR at some point in the near future. Phase two of the MRAC plan relates to SOFR cross-currency swaps and is the only phase with a set date of September 21, as endorsed by ARRC on July 21. The CFTC hopes to cease the issuance of new derivatives linked to LIBOR by December 31 and to continue to remediate legacy contracts that rely on LIBOR going forward, while also expanding the liquidity of SOFR and other alternative rates.
In addition to its recommendation of Term SOFR, ARRC recommended loan conventions and best practices when using Term SOFR in the business loan market. ARRC previously published materials on the use of SOFR "in arrears" and provided other SOFR-related guidance. It is important to understand that like LIBOR, Term SOFR is a forward-looking rate; it predicts the costs to borrow cash collateralized by treasury securities on the interbank markets in the future. Other SOFR rates are backward-looking, relying on the actual average of reported costs. By looking at the actual costs reported, backward-looking rates are more reliable and less likely to be manipulated, as LIBOR had been. LIBOR manipulation triggered the push toward developing a new rate in the first place, so a backwards-looking rate had immense appeal. However, a forward-looking rate, such as CME Term SOFR, would better capture the costs to the participants going forward based on "market expectations implied from leading derivatives markets," according the CME Group's website. This means that a market participant could hope that the forward-looking rate would better reflect the reality in the future by capturing their actual costs, which has great appeal to lenders.
In the new conventions, titled " Forward Looking Term SOFR and SOFR Averages (Applied in Advance) Conventions for Syndicated and Bilateral Business Loans," ARRC discusses how to use Term SOFR in new loans, comparing the existing SOFR rates based on SOFR past averages with the new forward-looking Term SOFR, as the two rates reflect "two different time periods, and use different day-count period conventions." The conventions also discuss the movement away from legacy LIBOR loans and their comparison with Term SOFR.
ARRC's best practices, titled " ARRC Best Practice Recommendations Related to Scope of Use of the Term Rate," discusses the use of Term SOFR in legacy contracts, highlighting how much effort has been put into recommending fallback language to ease the transition away from LIBOR. The best practices memo also includes new contract language, highlighting two key statements from ARRC. First, ARRC supports the use of Term SOFR as a companion to other forms of SOFR, not as a replacement. Second, ARRC does not recommend Term SOFR for the vast majority of the derivatives markets since SOFR already has a robust usage on those platforms and is relatively risk free — as it is backwards looking even if the forward-looking Term SOFR has its advantages. ARRC recommends proportionate use of Term SOFR in the derivatives markets to start.
The robust guidance on Term SOFR is another nail in LIBOR's coffin. While other rates still may have appeal, this marks a major step forward for the use of SOFR generally, and Term SOFR specifically, making the transition away from LIBOR all the easier.
