August 27, 2021 - by Tess Virmani. Today the ARRC released FAQs on its Term SOFR recommendation and related recommended use cases for Term SOFR. While the recommended use cases were clear that Term SOFR was appropriate for use in cash product fallbacks and new originations of business loans and CLOs, market participants have had questions relating to nuances of the ARRC’s inclusion of end-user derivatives on Term SOFR-referenced assets as an additional permitted use. The FAQs seek to clarify the ARRC’s position with respect to derivatives referencing Term SOFR as well as answering questions regarding the interplay of the ARRC recommendations with supervisory expectation and CME Group’s licensing arrangements. Of particular note, the ARRC reinforced its message that the use of Term SOFR is not supported for the vast majority of derivatives, including all interdealer activity. The ARRC does not recommend the trading of SOFR Term Rate derivatives in the interdealer market because such activity could undermine trading activity in the underlying overnight SOFR derivatives that are needed to construct the SOFR term rate itself and could, thereby, compromise the robustness of the rate and its corresponding utility to market participants. In general, the ARRC understands that dealers offering SOFR Term Rate derivatives to end users can effectively warehouse the risk associated with such offerings, including through the use of overnight SOFR derivatives. Limited derivatives activity where end users are seeking to hedge their exposure on Term SOFR-referenced assets is acceptable. For purposes of this scope of use, “end-user” should be interpreted to mean “a direct party or guarantor to a new SOFR Term Rate business loan or securitization linked to SOFR Term Rate assets, or to a legacy LIBOR product that has converted to the SOFR Term Rate through contractual fallback language or legislation.” An end user (for example, either a lender or borrower who have entered in to a SOFR Term Rate business loan), could enter in to a SOFR Term Rate swap, cap, swaption, or similar derivatives contract to hedge that SOFR Term Rate cash product exposure, or a portfolio of such exposures, and could adjust or unwind that hedge over time, including through novations. A dealer counterparty to these hedges would not be considered an end user under these recommendations, and the ARRC does not recommend that the dealer seek to hedge its own resulting SOFR Term Rate exposure with an additional SOFR Term Rate derivative.” However, “the ARRC recognizes that some lending institutions are not structured to make markets or warehouse the risk of offering derivatives products to end users but may wish to enter in to a SOFR Term Rate swap, cap, swaption, or similar derivative as part of their services to help a borrower hedge a SOFR Term Rate business loan. In this instance, provided that the institution does not make two-way prices in interest rate derivatives and is not a market maker in the interdealer market for such derivatives in the regular course of its business, the ARRC considers that the use of offsetting derivatives matching the derivatives exposure that the institution has offered to its borrowers would fall under the ARRC’s recommended use of a SOFR Term Rate derivative.”
Hopefully, this latest ARRC release answers any lingering questions of market participants and further paves the way for Term SOFR loan originations where parties wish to adopt Term SOFR in their new loan activity.