The transition from the London Interbank Offered Rate ("LIBOR") for United States dollars to its presumptive successor, the "risk-free" overnight Secured Overnight Financing Rate ("SOFR"), requires two adjustments to SOFR to be as "fungible" as possible with LIBOR: (i) the construction of an actual or synthetic term structure; and (ii) a credit spread adjustment to be added to the various tenors so constructed. The International Swaps and Derivatives Association, Inc. ("ISDA") determined some time ago that, for derivatives, term construction would be effected by means of compounding SOFR (and all other overnight reference rates globally) daily over the course of a given accrual period ("compounding in arrears") and taking the average as the “risk-free” rate for that accrual period. To this would be added a "spread adjustment" determined on a one-time basis (i.e., the credit spread would be "fixed" and not "dynamic") equal to the median daily spread between SOFR compounded in arrears for each tenor and its LIBOR equivalent over a period of five years preceding the applicable "trigger event," which is roughly when the precise timing of LIBOR cessation will become fixed.
The ARRC is the largely private sector body convened by the Federal Reserve to guide LIBOR transition in the United States. The ARRC launched its own market consultation ("First Consultation") on spread adjustment methodologies in January 2020 for "cash" market products (business loans, floating rate notes, securitizations and mortgages, and other consumer products). Unlike ISDA, however, the ARRC aspires to a "true" forward-looking term SOFR and is also continuing to consider a number of different "synthetic" term construction techniques that include, in addition to compounding in arrears, "compounding in advance" (compounding SOFR daily for the period equivalent to a given accrual period ending immediately prior to the accrual period such that the applicable rate will be known from the accrual period's commencement) and "simple" averaging of SOFR both in arrears and in advance.
The First Consultation requested market participant input on a number of questions, including whether the "ISDA methodology" (five-year median spread) or another methodology (other candidates included averages and "trimmed" medians and averages over a variety of time periods ranging from 3.5 to 10 years). The ARRC reported on May 6, 2020, that responses were nearly unanimous that the "ISDA methodology" should be utilized across all products.
However, the ARRC appears to have belatedly realized that the single "ISDA methodology" for up to five different rate/tenor sets has the potential to yield an overly complex set of spread adjustments, which although expected to be similar may not be identical. The ARRC accordingly seeks market input ("Second Consultation") as to whether simply to adopt the ISDA "value" (the determination of which, as provided by ISDA's "Adjustment Services Vendor," Bloomberg Index Services Limited, will be extraordinarily complex on its own) for all actual and synthetic term rate structures under consideration.
The Second Consultation also requests input as to whether the five-year measurement period for a "pre-cessation" trigger consisting of a regulatory declaration of "non-representativeness" should also be aligned with ISDA's, given ISDA's recent decision to adopt such a trigger. This "pre-cessation" trigger has existed within the ARRC's recommendations since the very start, but has proven more controversial for the derivatives markets.
The ARRC's proposed spread adjustment simplification is to be welcomed, even if perhaps at the expense of intellectual and financial purity. It would ensure alignment with derivatives for cash products that utilize SOFR compounded in arrears and avoid the need for multiple sets of spread adjustments. However, the Second Consultation also graphically demonstrates the complexities that can result from the number of term construction options remaining under consideration by the ARRC. Every decision threatens to be magnified exponentially and/or to be open for reconsideration as it gets propagated across various term construction techniques and actual tenors.