Forward looking SOFR with spread adjustments
Term SOFR
In line with its 2020 objectives published in April, the ARRC established its RFR process to select an administrator of a forward looking term SOFR rate. Given that the liquidity in SOFR derivatives will have developed sufficiently, the publication of the rate is aimed to commence during the first half of 2021.
The recommended administrator will use its proposed methodology and data sources to publish SOFR term rates of 1-month and 3-month maturities on a daily basis (6-month and 1-year maturities may be considered as well). Candidate administrators will be assessed against four ARRC-set pillars; Technical criteria, Firm Criteria, Public Policy Criteria and Calculation Methodology.
Why is the SOFR forward looking term rate highly desirable by participants in the cash markets? SOFR; an overnight rate, is replacing USD-LIBOR, a principally forward-looking rate of seven tenors. This means that SOFR doesn’t provide any visibility concerning future payments. Thus, for the rate be used on cash products with future interest payments, such as loans, there has to be a technical “manoeuvre”.
This could include compounding the overnight rate or building a forward-looking rate based on SOFR-linked derivatives. Industry bodies (e.g. ARRC or ISDA) have already proposed backward looking methodologies for compounding the overnight rate, either “in arrears” or “in advance”. Although compounding “in arrears” is considered the primary vehicle for LIBOR transition, certain participants prefer a forward-looking rate for many reasons.
Participants include relatively smaller firms who don’t possess the resources and technology to switch their systems to compounded SOFR. In addition, corporate treasurers may be in need of anticipated future cash flows for working capital management.
For example, a forward-looking rate is essential for setting interest rates on cash pooling agreements or the computation of late-payment penalties on accounts receivable and payable. Moreover, there are cash product issuers who want to meet the needs of clients who prefer variable rates that provide cash flow certainty. Therefore, forward looking SOFR would do the work for them.
Spread Adjustments
ARRC also seeks an administrator or administrators to calculate and publish daily indicative and static spreads and spread-adjusted rates. The spreads will be calculated for each of the seven LIBOR tenors currently published and will be applied on every “version” of SOFR - i.e. overnight, compounded “in arrears” or “in advance” and term SOFR once it is available. Candidate administrators will be assessed against four ARRC-defined pillars, namely Technical criteria, Firm Criteria, Public Policy Criteria and Communications Criteria.
Why are spread adjustments necessary for the transition? LIBOR includes an element of bank credit risk while SOFR is considered a risk-free rate. Spread adjustments are needed to capture this difference (together with additional factors such as differences in liquidity) when existing IBOR-referenced contracts fall back to SOFR once the famous benchmark ceases to exist. Practically, the spread adjustment reduces the need for value transfer among counterparties when transitioning a contract. The ARRC-recommended fallback language already defines such spread adjustments that are embedded to the respective “version” of SOFR.
The spread adjustment that ARRC will use is “static”, i.e. it will be calculated once once LIBOR ceases. The methodology is based on the historical median difference between LIBOR and SOFR over a five-year look-back period prior to the trigger event. In comparison to the RFP for the forward looking SOFR, the ARRC is not requesting candidate administrators to propose a methodology, but rather apply the recommended one.
It is worth noting that there are two spread adjustment calculations, one for commercial products and another for consumer products that will include a one-year transition period. The inclusion of this period in the calculation would smooth extreme differences between LIBOR and SOFR at LIBOR cessation versus, the historical median.
Fuelling the transition
The publication of the two RFPs does fuel the transition’s progress. On the one hand, the forward-looking term SOFR will unlock some market participants’ transition plans that have long been waiting for its publication. On the other hand, the spread adjustments are important for all LIBOR-linked contracts “falling back” to SOFR.
The methodology used by ARRC is in line with the one used by ISDA in the derivatives market thus enabling a level of coordination between the two markets that would be beneficial for participants (e.g. in terms of hedging purposes). The only difference lies in the inclusion of the transition period to the methodology for consumer products suggested by the ARRC.