March 7, 2019 - With LIBOR ending after 2021, the transition to a replacement rate (likely SOFR) is moving to the front of minds (and, now, to front office minds). The LSTA is helping smooth this process by participating in the Alternative Reference Rates Committee (ARRC), co-chairing the ARRC business loans working group and initiating the loan operations subgroup.
In recent months, we have focused on ensuring that the SOFR fixes – be they fallback language or new SOFR loans – can actually be operationalized in bank loan systems. At the LSTA Operations Conference on April 9th in NYC, we will dive deeply into SOFR transition issues. But to tide over interested members, below we recap recent Finastra and HIS Markit events in which we previewed SOFR operational challenges (and potential solutions).
Challenge #1: What’s your rate? As discussed last week, there are four potential SOFR replacement rates. Forward looking term SOFR, SOFR Compounded in Advance, SOFR Compounded in Arrears and Daily Simple SOFR. Most lenders prefer forward looking term SOFR, which would look and feel like LIBOR. However, the existence of a robust term SOFR cannot be guaranteed, so the other rates must be considered. At the Ops Conference, we will explain these approaches – and why SOFR Compounded in Advance alsolooks and feels like LIBOR (and can be operationalized more quickly).
Challenge #2: What’s your spread adjustment? Because SOFR is an overnight, risk free rate, there will need to be a one-time spread adjustment to normalize yields when SOFR loans replace existing LIBOR loans. ISDA is developing spread adjustments for the derivatives market; ARRC has agreed to work on this for cash markets. At the Ops Conference, we’ll explain why these spread adjustments are likely to be very similar.
Challenge #3: Where do you get SOFR rates? Market participants are discussing the need for i) SOFR, ii) Spread Adjustment, and iii) Adjusted SOFR (SOFR+spread adjustment) to be available on Bloomberg and Reuters screens. We hope that, by the Ops Conference, we’ll have more clarity into what rates will be published and where.
Challenge #4: How will conventions change? The LIBOR-based loan market has many conventions. If the replacement rate is Term SOFR or SOFR Compounded in Advance (i.e., rates that are locked in at the beginning of a loan contract), many of these conventions may remain the same. If the replacement rate is Daily SOFR or SOFR Compounded in Arrears (i.e., rates that change during a loan contract), loan market conventions will have to change. We’ll explain the latest thinking at the Ops Conference.
While we flagged these issues on a Finastra Webcast Wednesday, these are not simply US issues. At a London IHS Markit Conference last week, similar global issues emerged. The FCA reminded attendees that i) LIBOR is highly likely to end, ii) that waiting for a term rate is not a good idea when rates like Compounded SONIA are available today, and iii) that they, like the US, are working on conventions. Conversely, a treasurer representative noted that borrowers need certainty around costs and flows, which is why they want a forward rate. Meanwhile, bank loan systems will require major changes to shift to an “in arrears” rate. This is the same tension that we see in the US – and that we will discuss (and hopefully help resolve) at the LSTA Operations Conference.