December 5, 2018 - LSTA members should be well apprised of the ARRC consultation on syndicated loans for which the comment period recently ended. Several of the key questions in that consultation are “what is the right fallback rate (eg, forward looking term SOFR, compounded SOFR (in advance or in arrears) or overnight SOFR)” and “how to create a spread adjustment that makes secured, risk-free SOFR more like LIBOR”.

These questions may be partly informed by ISDA’s recent consultation on certain aspects of fallbacks for derivatives referencing Pound Sterling LIBOR, Swiss Franc LIBOR, Yen LIBOR, TIBOR, Euroyen TIBOR and BBSW.  This is the first of ISDA’s consultations on fallback rates and spread methodologies. The purpose of the ISDA consultation is to determine the (highly) technical approach for calculating adjustments to the underlying fallback rates and spread adjustments that would apply if an IBOR is permanently discontinued and derivatives fallbacks are triggered. Last week, ISDA released preliminary results from this consultation. In total, ISDA received 152 responses from a variety of financial market participants from a number of jurisdictions. While these results are still subject to the ongoing work to inform an ultimate decision of the ISDA Board Benchmark Committee, the results did show clear preferences among the respondents. The ISDA statement indicates that “the overwhelming majority of respondents preferred the ‘compounded in arrears rate’ for the adjusted risk-free rate (RFR), and a significant majority across different types of market participants preferred the ‘historical mean/median approach’ for the spread adjustment.”  Furthermore, respondents indicated that it is preferable for the same adjusted RFR and spread adjustment to be used across all benchmarks covered by the consultation. Based on these responses, ISDA expects to proceed with developing fallbacks for inclusion in its standard definition based on the compounded setting in arrears rate and the historical mean/median approach (which takes the historical difference between the IBOR and the relevant RFR over a long period) to the spread adjustment for all of the benchmarks covered by the consultation. ISDA intends to publish the ISDA Board Benchmark Committee’s final recommendation by the end of the year. Now, USD LIBOR was not a part of this consultation and will be the subject of its own consultation in early 2019, however, ISDA ‘s statement further indicated that this approach may also be appropriate for USD LIBOR and potentially other benchmarks (including EUR LIBOR and EURIBOR).

What does this mean for loans?

It is too soon to say, but it may be of some comfort that, instead of falling back to an overnight rate, the ISDA fallbacks will likely be to a term rate, i.e. a rate compounded in arrears.  While the results of the ARRC loan fallback consultation are not yet public, anecdotally participants in the cash markets have generally indicated a preference for a forward looking term version of SOFR, which is currently not yet available, for use in their fallbacks. Contrastingly, as Appendix IV of the ARRC consultation on syndicated loans makes clear, derivatives fallbacks will not be to forward-looking term rates, irrespective of whether the ARRC recommends a forward-looking term SOFR for cash markets.  If cash markets select a forward-looking term rate while derivatives select a compounded rate in their fallbacks, there will be a misalignment between loans and their hedges. However, this will not be as great a misalignment as there would be if the derivatives fallbacks included one of the other overnight versions of SOFR that were considered. We know that the derivatives market is not planning to conform to cash market norms; conversely, we will see how ISDA’s selection affects the view of cash market participants, if at all.

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