April 21, 2021 - In March, the Alternative Reference Rates Committee stated that it i) might not recommend a term SOFR rate by YE2021 and ii) was “evaluating the limited set of cases in which it believes a term rate could be used.” Lenders became concerned that a term rate might not become available for business loans. Yesterday, the ARRC announced key principles that would guide it as it considers conditions necessary to recommend a Term SOFR rate and today the CME announced the launch of a Term SOFR rate that aligns with ARRC principles. Together, these two announcements suggest that perhaps there is a way forward to Term SOFR for those cash products that truly do need one, as long as their need does not overwhelm the SOFR derivatives market. We discuss these issues below.
To be clear, in this week’s announcement, the ARRC – citing the supervisory guidance in place – still encourages market participants not to wait for a term rate and to use the SOFR alternatives available now. However, the ARRC also is moving to quickly lay out the principles to help market participants to understand the likelihood and potential timing of a recommended term rate. The ARRC’s three key principles are that a term rate should:
- Meet the ARRC’s criteria for alternative reference rates, similar to SOFR itself;
- Be rooted in a robust and sustainable base of derivatives transactions over time, to ensure that its use as a reference rate is consistent with best practices and the ARRC’s own standards; and,
- Have a limited scope of use, to avoid (i) use that is not in proportion to the depth and transactions in the underlying derivatives market or (ii) use that materially detracts from volumes in the underlying SOFR-linked derivatives transactions that are relied upon to construct a term rate, making the term rate itself unstable over time.
Meanwhile, movement on Term SOFR was underlined when, on Wednesday, the CME announced the launch of Term SOFR rates for 1M, 3M and 6M tenors. Importantly, the CME announced that its Term SOFR is aligned with ARRC Principles, is IOSCO and BMR compliant and is based on the CME Group’s deep and liquid underlying SOFR futures. The CME noted that they “are supportive of the ARRC’s forward term rate principles and believe our SOFR Term Rates comply with and advance the ARRC’s criteria, rooting these new tools in CME SOFR futures.” Noting that the ARRC principles state that any forward term rate should have a limited scope of use so it does not impact volumes in the underlying SOFR-linked derivatives transactions, the CME Group said it would limit the licensing of its SOFR Term Rates to cash market transactions (such as loans) until June 30, 2023. Licensing will be available at no charge for this period.
As noted above, these two announcements together suggest that perhaps there is a way forward to Term SOFR for those cash products that truly do need one, as long as their need does not overwhelm the SOFR derivatives market.