Differences in approach to contractual fallback language recommendations across asset classes show that while cash products and derivatives are moving in the same direction on benchmark reform, at this stage they are not fully aligned.
The Alternative Reference Rates Committee (ARRC) released final recommended contractual fallback language for US dollar Libor-denominated floating rate notes (FRN) and syndicated loans last week, and will soon make similar issuances for bilateral business loans and securitisations.
The International Swaps and Derivatives Association (Isda) has not yet released its own final language for the derivatives industry. But based on the final results of its benchmark fallbacks consultation, it can be attested that, while similar, the approach will deviate from cash markets.
“If we take the lessons learned from the Isda consultation at the end of last year for other currencies, we have a good idea that it will opt for a compounded secured overnight financing rate (SOFR) in arrears replacement rate,” said Tess Virmani, associate general counsel at Loan Syndications & Trading Association (LSTA), which led the drafting of the language for the syndicated loans space.
This would draw from the historical main median approach for the spread adjustment.
However, for the cash markets – syndicated loans, bilateral loans, floating rate notes and securitisations – the preference is to fall back to forward-looking term SOFR rates.
- Variations in approach to contractual fallback language recommendations across asset classes show that while cash products and derivatives are moving in the same direction, at this stage they are not totally aligned;
- The ARRC released final recommended contractual fallback language for US dollar Libor-denominated floating rate notes and syndicated loans last week;
- The Isda consultation at the end of 2018 for other currencies suggests that derivatives will opt for compounded SOFR in arrears;
- However, for the cash markets – syndicated loans, bilateral loans, floating rate notes and securitisations – the preference of market participants is to fall back to forward-looking term SOFR;
- It is encouraging that the cash markets have narrowed trigger events to be more closely aligned with derivatives.
A forward-looking term SOFR rate behaves more like Libor than other variations of SOFR. The underlying nature of SOFR is different, but it can be used in the same way as Libor because it too is a forward-looking term rate, where the interest rate is set at the beginning of the interest period. There would be far less change in terms of systems and infrastructure needed if firms were to continue to use a forward-looking rate.
“If Isda is not going to include in its fallback language a forward-looking term rate, then we already know there is a chance that cash products and derivatives will deviate, at least in terms of the first choice rate when it comes to a successor,” she added.
“From an ideological perspective, everyone would like to see as much alignment across products as possible.”
Not ready yet
The ARRC’s proposal is that the first alternative to calculating SOFR will be term SOFR or something based on Libor like a three-month SOFR rate, which would not be calculated in arrears. “What the ARRC proposed they did so pragmatically. The problem is that term SOFR doesn’t exist yet, compounded SOFR doesn’t have a publicly available source where it can be reached easily, and has only been issued in small amounts,” said a general counsel at a major US bank.
What has appeared more frequently in the more than $70 billion worth of bond issues so far has overwhelmingly been a simple average SOFR, which is not what Isda will use. The likelihood is that eventually, the bond markets will switch over to compounded SOFR once there are tools available, which will mean issuers can easily calculate the rate and have it available to hand.
For loan operational purposes and for calculating bond interest and accrued interest, however, there are no readily available tools to calculate compounded SOFR.
“Money market funds don’t have the systems available to use compounded SOFR. So far the bond market has operated on simple average SOFR. Eventually it will evolve into compounded SOFR,” added the general counsel. “But the derivatives market doesn’t appear to be going to term SOFR. It appears to be settled on compounded SOFR.”
One of the main objectives of the ARRC is to focus on fallback language as a first step in the inevitable decline of Libor. Looking at the language itself, one of the main objectives of the ARRC was as much alignment across asset classes as possible in the interest of reducing systemic risk.
Whether there even will be a forward-looking term SOFR rate available at the time of transition is another uncertainty. While the ARRC has said that if there is a robust forward-looking term rate developed by that point then it will recommend that rate primarily, it is not a given.
According to Ann Battle, assistant general counsel at Isda, variations are related to inherent differences in the products.
“That is exactly how it should be,” she added. “The language should be consistent but tailored to the specific product and the relevant legal documentation.”
The language published by the ARRC received multiple market responses. From the final consultation being published up until the language was finalised, one changes was the number of pre-cessation trigger events that would cause the move from Libor to SOFR.
The balance was that cash markets very much want pre-cessation triggers, and at this stage the derivatives market has only published permanent cessation triggers.
“Everybody recognises that it is desirable for the cash and derivatives markets to be as aligned as possible. What that means for cash products is reducing the number of pre-cessation triggers,” said Lary Stromfeld, partner at Cadwalader, who is working with the ARRC to draft fallback language.
“At the same time Isda has offered to do a consultation on adding a pre-cessation trigger, and if we get to that point, then cash and derivatives will be much more aligned,” he added. “At this stage it is encouraging that cash markets are narrowing their trigger events, and Isda is looking to add one.”