Much like the month of March, the initial multi-currency phase of the London Inter-Bank Offered Rate (LIBOR) remediation went in like a lion and out like a lamb. The much-discussed Dec. 31, 2021 date for LIBOR remediation in relation to foreign currencies, including euros, pound sterling, Swiss francs, and Japanese yen, came and went with little to no fanfare. After intense planning, speculation, and worry regarding LIBOR remediation in multi-currency credit facilities in the U.S., followed by an initial flurry of amendments, many market participants ultimately decided to leave certain existing facilities unchanged. While regulators never issued any directives regarding the illegality of multi-currency facilities using LIBOR, it is widely understood that newly originated credit facilities should be using LIBOR alternatives going forward as LIBOR publication has ceased for certain tenors, and this will continue. In April, attention shifted to the remediation of some U.S. dollar (USD) LIBOR credit facilities, but not many.
The financial industry’s focus shift to the remediation of LIBOR in USD-denominated credit facilities has been slow. In March of 2021, the UK Financial Conduct Authority and the ICE Benchmark Administrator released joint statements confirming that the one-month, three-month, and six-month tenors of LIBOR would not be published after June 30, 2023. In 2021, the regulators explained that while the LIBOR cessation date for USD was ultimately pushed back to 2023, to allow the natural expiration of existing credit facilities, any newly originated credit facilities should include one of the newly introduced LIBOR alternatives, which include both credit sensitive rates and risk-free rates, both of which have proponents throughout the industry.
Credit sensitive rates are benchmarks that account for, and attempt to measure, the credit risk component of unsecured borrowing.1 Though credit sensitive rates offer improved approaches to rate determination, regulatory concern exists that the same issues that arose with regard to LIBOR, may also arise when using credit sensitive rates, specifically, the lack of sufficient underlying transaction volume, which could lead to the same potential manipulation and stability issues that exist with LIBOR.2 Some lenders are pushing for the adoption and consideration of credit sensitive rates because credit sensitive rates also include the lender’s cost of funds as a factor in determining such rates, in addition to the consideration of credit risk discussed above. The use of credit sensitive rates has not been widely adopted.
The secured overnight financing rate (SOFR), on the other hand, is considered “risk-free” because the overnight loans made via Treasury bond repurchase agreements (i.e. repos) that make up the volume of transactions on which SOFR is based are collateralized by U.S. Treasury securities. The collateralization of these obligations eliminates the credit risk component of unsecured transactions like those that make up the basis for LIBOR and other credit sensitive rates. One of the challenges for lenders associated with the adoption of risk-free rates moving forward is that the applicable lender’s cost of funds may rise while SOFR remains largely static during the volatile period at issue.3 While credit sensitive rates may have some attractive attributes, they have not been widely used in the market as a replacement for LIBOR. On the contrary, the consensus is that risk-free rates are the preferred successor to LIBOR, with SOFR being the preferred risk-free rate.
Daily Simple SOFR was initially considered to be the primary SOFR option until the Alternative Reference Rates Committee's (ARRC) formal recommendation of Term SOFR (hereinafter defined). Daily Simple SOFR operates similarly to the prime rate and base rate currently used in credit facilities in the marketplace. Daily Simple SOFR fluctuates daily, and the rate is generally not known until the end of the applicable interest rate, which may be unattractive to potential borrowers.4 Generally, a lookback period is associated with the use of Daily Simple SOFR, whereby the interest rate for a particular day in the interest period is actually the interest rate from a set number of business days earlier. A lookback period equal to two to five business days has been established as the prevailing industry standard for the time being; however, some market participants have indicated that lookback periods outside of two to five business days are permissible.
The CME term SOFR reference rate (Term SOFR), as administrated by CME Group, was formally endorsed by ARRC in July of 2021. Term SOFR is a forward-looking term rate, calculated daily, and published in the following tenors: one-month, three-month, six-month, and 12-month.5 Since Term SOFR is a forward-looking term rate, it does not require the use of a lookback period. CME Group has indicated that market participants desiring to use Term SOFR must obtain a license for such use, even if the rate is accessed through a third party. Such licenses will be available for free to market participants until December 2026. The marketplace has widely adopted benchmark transition event language that, upon the occurrence of certain trigger events, prompts the automatic fallback to either Term SOFR, or Daily Simple SOFR, as agreed upon by the applicable borrower and administrative agent.
Prior to the availability of Term SOFR, the Federal Reserve Bank of New York (NYFRB) created Average SOFR, a rate with fixed interest periods similar to LIBOR by calculating the compounded averages of SOFR over 30-, 90-, and 180-day periods.6 While there has not been the adoption of Average SOFR as an alternative to Term SOFR in the commercial banking market, there do appear to be segments of other markets, like asset-backed securities, mortgage-backed securities, and commercial mortgage-backed securities that contemplated and have used 30-day Average SOFR (applied in advance). According to ARRC, members of its Securitizations Working Group (SWG) prefer the 30-day Average SOFR calculation for a few reasons. One such reason is that the 30-day Average SOFR is analogous to LIBOR in that it does not require further calculation.7 Moreover, the 30-day Average SOFR helps to ease the issues that may arise under the 90-day and 180-day tenors, including, without limitation, the fact that those longer tenors often may not reflect the current rate throughout the entire interest period.8 30-day Average SOFR can be calculated both in advance and in arrears.9 Calculating the 30-day Average SOFR in advance means that the rate is calculated on the first day of the interest period, and reflects the average of SOFR for the 30-day period prior to the interest period, whereas, the 30-day Average SOFR calculated in arrears is calculated at the end of the applicable interest period, and reflects the average of SOFR for the most recent 30-day period.10 While some market participants prefer calculating the interest rate in arrears because it provides a more accurate rate that reflects the actual marketplace during the applicable interest period, calculating the interest rate in advance may be advantageous to lenders, and borrowers, as the interest rate is known to the parties at the beginning of the interest period, thereby making it easier to plan ahead.11 Additionally, a 30-day Average SOFR in arrears, while a more accurate reflection of the marketplace during the interest period, will be much more difficult to operationalize.12
Yet another SOFR derivative, Compounded SOFR in Arrears combines features of both Daily Simple SOFR and Average SOFR. Compounded SOFR in Arrears is substantially similar to Average SOFR in that it is compounded daily for the preceding 30-day, 90-day, or 180-day interest periods. Similar to Daily Simple SOFR, the actual interest rate is not known until the end of the applicable interest period. As such, borrowers may prefer SOFR variations where the rate is available at the beginning of the applicable interest period, as such a structure provides borrowers the opportunity to plan ahead financially. Compounded SOFR in Arrears is the preferred variation of SOFR for the International Swaps and Derivatives Association.13
Taft continues to provide leadership in this transition and provides legal updates on issues impacting its clients. Taft’s LIBOR transition team provides advice and thought leadership on the many challenges associated with the LIBOR transition. Please contact the team with any questions or if it can be of assistance regarding this transition or any other finance law needs.
4Expert Q&A on LIBOR Transition: Issues for Borrowers to Consider, Practical Law Article
6Expert Q&A on LIBOR Transition: Issues for Borrowers to Consider, Practical Law Article
7Options for Using SOFR in New ABS, MBS, and CMBS Products, Alternative Reference Rates Committee – March 2021
8Options for Using SOFR in New ABS, MBS, and CMBS Products, Alternative Reference Rates Committee – March 2021
9Options for Using SOFR in New ABS, MBS, and CMBS Products, Alternative Reference Rates Committee – March 2021
10Options for Using SOFR in New ABS, MBS, and CMBS Products, Alternative Reference Rates Committee – March 2021
11Options for Using SOFR in New ABS, MBS, and CMBS Products, Alternative Reference Rates Committee – March 2021
12Options for Using SOFR in New ABS, MBS, and CMBS Products, Alternative Reference Rates Committee – March 2021
13Expert Q&A on LIBOR Transition: Issues for Borrowers to Consider, Practical Law Article