August 12, 2020 - Last Friday, the Alternative Reference Rates Committee (“ARRC”) released a “SOFR Starter Kit”, a helpful set of fact sheets to turn SOFR neophytes into SOFR acolytes. We go into a bit of detail below, but gently suggest an in-depth review of the kits themselves.
The first fact sheet dives into the history and performance of LIBOR, discusses why it’s going away, and describes SOFR and how it was selected. Specifically, it explains that USD LIBOR is calculated primarily from “expert judgement” – i.e., the rate at which 16 submitting banks think they could borrow. Banks must estimate this rate because there are few actual “interbank” loans to observe. Interbank lending has declined markedly since 2008 as banks shifted to longer-term funding models. Recognizing the problem – and the inability to reform a rate that is underpinned by few transactions – the ARRC was formed in 2014 to find a replacement rate and support a transition. The ARRC undertook an extensive evaluation and consultation process to find a robust and sustainable replacement rate; potential replacements included term unsecured rates, overnight unsecured rates, term secured rates, overnight secured rates, and Treasury bill and bond rates. Ultimately SOFR – an overnight secured rate – was selected as the most robust and sustainable rate.
The second fact sheet picks up the story and dives into the details about SOFR. First, it notes that SOFR is comprised of three broad Treasury repo rates. The overnight Treasury repo market is deep and robust, is based entirely on transactions (not estimates) and boasts a diverse set of borrowers and lenders. With some $1 trillion of daily trading, the Treasury repo market is not likely to go away. (And with LIBOR transition a painful process, no one wants to have to transition a second time!) The fact sheet also corrects misconceptions about SOFR. To wit, SOFR is not more volatile than LIBOR (because some version of a “tenored” SOFR will be used in cash contracts). Second, waiting for a term SOFR is a mistake because i) it may not emerge as a reference rate before LIBOR ends and ii) the use of SOFR averages today will facilitate the development of term SOFR tomorrow (and, conversely, if folks don’t use SOFR averages today, term SOFR won’t develop). Third, SOFR is, in fact, useable for broad swaths and different types of markets (but the ARRC also supports the development of other robust and sustainable rates). Fourth, and critically, we cannot presume that the Covid-19 crisis has changed the LIBOR cessation date. That is in the hands of the banks that submit LIBOR, not the ARRC or the Fed.
The third fact sheet describes SOFR Best Practices, Users’ Guide and other tools. The best practices identify key milestones (like when new products should be fully transitioned to hardwired fallbacks, when to stop LIBOR loan originations), timeframes and preconditions. The Users’ Guide explains how a number of variants – like Simple and Compounded SOFR – work, as well as their trade-offs. Finally, the fact sheet describes tools that have been developed, such as conventions (which explain the technical details of how to implement SOFR loans) and fallback language (which provides contract language to permit loans to fall back from LIBOR to SOFR). Together or separately, these easy-to-digest fact sheets can familiarize lenders and borrowers with SOFR and provide links (and deep dives) to in-depth reference documents.