June 15, 2021 - by Meredith Coffey. Last week might have been a pivotal one for LIBOR transition. On Tuesday, collective announcements by the CFTC and the ARRC indicated that ARRC-recommended CME Term SOFR should be ready for use in loans by the end of summer. On Friday, the Financial Stability Oversight Council (“FSOC”) held a public meeting on LIBOR transition, and the heads of regulatory agencies professed both a preference for SOFR and reluctance to endorse credit sensitive rates (“CSRs”) – at least for derivatives and capital markets transactions. Collectively, these actions might – emphasis on might – swing sentiment toward Term SOFR. We discuss these developments below.
Last Tuesday, the CFTC’s Market Risk Advisory Committee’s (MRAC) Interest Rate Benchmark Reform Subcommittee recommended a market best practice (“SOFR First”) beginning July 26th for “interdealer brokers [to] replace trading of LIBOR linear swaps with trading of SOFR linear swaps. This step will cause trading activity amongst swap dealers on these platforms…to switch from LIBOR to SOFR.” This should create a substantial increase in SOFR liquidity and a corresponding decrease in LIBOR liquidity, and thus should cement SOFR as the derivatives replacement for USD LIBOR.
Why we care: The SOFR First announcement should expedite the ARRC’s recommendation of Term SOFR in cash products, presumably including business loans. Indeed, the ARRC welcomed MRAC’s SOFR First announcement, noting that it would “support its formal recommendation of the CME SOFR term rates.” Federal Reserve Vice Chair Randal Quarles added that “term SOFR will be available upon implementation of the change in quoting conventions.”
But when will Term SOFR be recommended? At Tuesday’s SOFR Symposium, at minute 61, Tom Wipf, Chairman of the ARRC, stated, “If we can deliver on SOFR First…I think the ARRC will be well positioned in days, not weeks, following that July 26 date to endorse CME term SOFR.” So, Term SOFR for loans may come as soon as late July!
And then the supervisors weighed in. At Friday’s FSOC Meeting, regulators gave full-throated support to Term SOFR and were notably less enthusiastic about CSRs. Running from minute 8-15 of the meeting, Fed VC Randal Quarles discussed the imminent demise of LIBOR and strongly supported Term SOFR for many products. While Mr. Quarles reiterated that borrowers and lenders were free to choose the replacement rate on newly originated loans, they should make that decision with awareness of how the reference rate is constructed, any fragilities in it and the markets that underlie it, and that strong fallback language must exist in case the reference rate ceases in the future (11:40). Meanwhile, “derivatives and capital markets products” must have reference rates determined in a stable structure, such as SOFR. He flagged that the ARRC does not support more than minimal use of “other rates” in capital markets or derivatives and market participants should not expect such rates to be widely available (13:00). He added that supervisory guidance shows that (for non-capital markets) lenders and borrowers are free to choose the rates that meet their needs…but term SOFR will play a role in these markets as well.
While Fed VC Quarles preferred Term SOFR but acknowledged the potential use of CSRs outside of derivatives and capital markets products, SEC Chair Gensler was more…direct. If one is interested in the relationships between naked emperors, pyramids, Warren Buffet, swimming trunkless and BSBY, Mr. Gensler’s written statement and statement (20:24) are worth reviewing. But, bottom line, he suggested that BSBY had similar flaws as LIBOR and that it is not “especially robust.”
So where does this leave us? Between CME Term SOFR almost definitely available for new originations by the end of summer and the regulators quietly supporting Term SOFR and discouraging CSRs, it would appear that Term SOFR likely still is in the loan market game. And, of course, the LSTA continues to work to effectuate all potential replacement rates.