- An IOSCO-Compliant Forward Looking Term SOFR reference rate may not develop in time for use in syndicated loan fallbacks or pre-LIBOR cessation SOFR loans
- A recently-published ARRC document explains how SOFR liquidity could build, as well as how limiting the use of a Forward Looking Term SOFR might increase its viability
- The other potential SOFR rates for syndicated loans are SOFR Compounded in Arrears, Simple Daily SOFR in Arrears, or SOFR Compounded in Advance
December 10, 2019 - The syndicated loan market would really like an IOSCO-compliant Forward Looking Term SOFR to develop. If such a rate developed, it would solve several problems inherent in SOFR. A forward looking rate would be known at the beginning of an interest period (as LIBOR is today), it would simply embed the “time value of money” (as LIBOR does today) and it would obviate the need to create “time value of money” by compounding a rate during the interest period. However, an IOSCO-compliant Forward Looking Term SOFR reference rate may not develop quickly enough or robustly enough to be widely used in syndicated loan fallbacks or SOFR loans.
The minutes from the October ARRC meeting include a Fed presentation – “Futures Market Trading Volume and SOFR Term Rates” – that demonstrate the challenges. In effect, an active SOFR futures market should allow market participants to create forward-looking term rates. (Indeed, the Fed already is publishing indicative forward looking term SOFR rates.) The issue is whether there is enough futures trading to create forward looking term SOFR rates that are robust, sufficiently stable and immune to manipulation – and thus can be used as IOSCO-compliant reference rates for a wide swath of the market. The jury is still out on that one.
The Fed presentation compares the liquidity of Fed Funds futures to SOFR futures trading, demonstrating that Fed Funds futures trading is far higher than SOFR today (pages 11-15). On pages 16-17, the Fed ventures into Greek letters to demonstrate that lower levels of trading can lead to a bigger price impact on futures – and presumably to bigger impacts on any potential forward looking term rate.
The Fed concludes by suggesting caution in moving toward futures-implied term rates until daily SOFR futures volume and liquidity build further. (We would note that SOFR trades may increase materially in a “Big Bang” next year, when the clearing houses shift to SOFR discounting.) The Fed adds that IOSCO principles embed a concept of “proportionality”, recognizing that the more widely a reference rate is used, the more robust it needs to be. There is two ways this impacts the market: If a forward looking term SOFR reference rate is very widely used, the futures markets need to be extremely robust and resilient. In contrast, if term rates were limited to use cases where they were really, truly needed – which might not be the sophisticated end of the syndicated loan market – then a term rate could be developed more quickly.
For these reasons, we are not putting all our eggs in the “term SOFR” basket. Instead, the ARRC Business Loans Working Group, which is co-chaired by the LSTA, is examining the feasibility of other SOFR rates, with a particular focus on SOFR Compounded in Arrears and Simple Daily SOFR in Arrears. Please feel free to reach out to us via firstname.lastname@example.org or join the LSTA Weekly LIBOR calls for more information.