October 10, 2019 - We’d be the first to acknowledge that transitioning from LIBOR to SOFR is hard. But LIBOR will end and we must prepare. Recognizing that, the September 5, 2019 Alternative Reference Rate Committee (“ARRC”) minutes introduced two tools to help ease the transition. (See the presentation starting on p. 15 of the minutes.) The first is an official SOFR Compound Average and the second is a “SOFR Index”. We describe both tools – and their use cases – below. Importantly, the Federal Reserve will be releasing consultations shortly and looks to launch both products in first half 2020.
The first tool is a set of official “Compound Averages” of SOFR the previous 30, 90 and 180 days. (While “indicative” Compounded SOFR and Forward Looking Term SOFR rates already are available, the Fed is looking to publish official compounded SOFR rates.) The benefit of the official rate is that by simply plucking them off a screen, borrowers and lenders would know the compounded SOFR for those periods. This could be particularly useful for products that use “SOFR Compounded in Advance”, i.e., the SOFR that is determined by compounding the daily SOFR rate before the interest period begins. The Fed presentation notes that the publication of these rates could facilitate adoption of SOFR, particularly for markets such as consumer loans and adjustable rate mortgages.
Over here in the syndicated loan space, four SOFR rates are under consideration for use. The first two – Forward Looking Term SOFR and SOFR Compounded in Advance – are similar to LIBOR in that the rate is known in advance of the interest period. The second two – Simple SOFR in Arrears and SOFR Compounded in Arrears – are very different than LIBOR in that the rate is not known at the beginning of the period and is accrued over the life of the loan contract.
It is quite possible that the loan market will end up with SOFR Compounded in Arrears – and it is here that a SOFR Index could prove very useful. Basically a SOFR Index would internalize compounding for a SOFR Compounded in Arrears product. The Index would start at “1” on the first day SOFR was published – April 2, 2018 – and be compounded by the SOFR rate every day thereafter. There are (at least) three very nice things about the SOFR Index. First, it would automatically internalize all the day count, rounding, weighting, “lookback” and compounding conventions that the market decides to use. Thus, it would not be possible for a borrower and lender to inadvertently use different conventions and therefore calculate different interest payments that need to be made. (This is a real threat if conventions are not locked down and used consistently.) Second, it very much simplifies the process by which systems would compound interest rates. Instead of pulling SOFR daily and compounding inside a system for every loan, a loan system can simply pull the SOFR index and do the following very simple calculation to determine the accrued interest for any period of time:
(SOFR Indexend/SOFR Indexstart – 1) x (360/calendar days from start to end)
This is far less complicated than the internal calculation (see p. 20 of the minutes for a numerical example). Third, it will be very easy to build “SOFR Calculators” for unsophisticated parties to see what their interest rates are and how their interest charges are accruing. Thus, the SOFR Index could simplify the “Compounded in Arrears” world substantially.
So when will these useful tools emerge? The Fed plans to issue a consultation shortly and roll them out in the first half of 2020. The LSTA is a member of the ARRC and co-chairs the ARRC’s Business Loan Working Group and Operations Subgroup. If members have questions, please contact email@example.com for policy and market issues, firstname.lastname@example.org for legal and document issues and email@example.com for operations issues.