February 18, 2021 - In January, the Federal Reserve Bank of New York (“FRBNY”) invited the LSTA to present to its Credit Sensitivity Group (“CSG”) on i) lessons learned in implementing SOFR in the loan market and ii) how such lessons might apply to the implementation of a credit sensitive rate (“CSR”). Below, we provide context to the CSG meetings, recap the takeaways from the session and review the LSTA’s lessons (and their applicability to CSRs). All of this also is available in the 33 pages of CSG meeting minutes.
First, a little context: In 2020, the Fed, OCC, FDIC and Treasury held a series of CSG workshops to “discuss ways to support the transition of loan products away from LIBOR”. Following the workshops, the official sector participants sent a letter to the banks. The January 2021 workshop minutes highlighted several key takeaways from the letter: (1) “Market participants should seek to transition away from LIBOR in a manner that is most appropriate given their specific circumstances.” (2) “The official sector supports the continued innovation in, and development of, suitable reference rates, including those that have credit sensitive elements.” (3) “Banks may seek different characteristics when selecting an alternative reference rate…based on their own profile and business needs.” (4) “The terms of a commercial loan…are negotiated between the lending and borrowing parties to a transaction.” Ultimately, the letter noted that “the official sector is not well positioned to adjudicate the selection of a reference rate between banks and their commercial customers (emphasis added)”.
While they might not want to adjudicate, the official sector did not appear averse to helping the private sector think about developing tools on their own. To that end, the FRBNY stated that “the purpose of this second and final working session [on January 14, 2021], the Implementation Forum, is to bring together a diverse set of banks and borrowers involved in prior Credit Sensitivity Group workshops and other relevant parties to review the implementation framework for commercial loan products amid the transition away from USD LIBOR, including how that framework could accommodate a diversity of potential rate inputs (emphasis added).”
As discussed in the minutes, one bank observed that there is extensive work involved in vetting and standing up a robust LIBOR alternative. But extensive work does not preclude the emergence of a CSR as “[s]ome banks noted that they were preparing for a multi‐rate environment in the future where different rates might suit different client needs, indicating, for example, that some banks could offer SOFR‐based loans alongside loans based on a credit sensitive rate/spread to SOFR.”
Still, replacement rates also must be executed quickly, as “[g]iven recent supervisory guidance to stop entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021, many forum participants highlighted the importance of first operationalizing a plan that can be implemented with tools available now, recognizing that the market may continue to evolve over time.”
To help facilitate the bank goals identified above, the LSTA presented on i) lessons learned from implementing SOFR and ii) how these lessons might be applied to credit sensitive rates (see pps 12-25 of the minutes). The LSTA co-chairs the ARRC’s Business Loans Working Group (“BLWG”) and has worked on i) SOFR Conventions, ii) SOFR Operationalization and iii) SOFR Documentation. These three workstreams all intersect and inform each other. As just one example, conventions define how systems will work but, at the same time, one must not create conventions that cannot be operationalized.
In order to make the Conventions, Ops and Docs streams work together, the BLWG identified the “architecture” of each potential SOFR rate. The first “architecture” reflected a rate that, like LIBOR, is “known in advance” of the interest period; this included Forward Looking Term SOFR and SOFR Compounded in Advance. Because these “known in advance” rates largely act like LIBOR, conventions, systems and documents would not require material change. Second, Daily “Simple” SOFR had an architecture similar to daily LIBOR or daily Prime loans, where the rates were pulled daily, but no calculations were performed. Daily Simple SOFR loans would require refinements to conventions (like adding lookbacks), systems (like adding spread adjustments) and documentation and would require far more information flowing through the “pipes”, but they were not a totally foreign concept. The “Daily Compounded SOFR” architecture was quite foreign to the loan market because it required pulling a rate daily and then applying substantial calculations to it.
The “architecture” framework developed for SOFR could be applied to CSRs as well. As p. 32 of the CSG minutes demonstrate, an immediate question is whether a CSR would be a rate or a spread over SOFR. A “known in advance” rate likely would be operationalized very much like LIBOR. Meanwhile, a “known in advance” spread over term SOFR may be similar to LIBOR, but would require systems to add additional fields. If a credit sensitive spread were applied to a daily SOFR rate, then we would be moving into the “Daily Simple” or “Daily Compounded” architectures. An additional decision point may be whether the credit sensitive spread adjustment would be locked at the beginning of the interest period – which might simplify hedging – or whether the credit sensitive spread adjustment would vary daily along with the Daily SOFR rate.
Ultimately, the sorts of questions – and lessons – that were addressed in solving SOFR, theoretically could be very applicable to solving CSRs as well. For more information on rate “architectures”, contact email@example.com.