Secured Overnight Financing Rate (“SOFR”) in Arrears or Term? – Published with Legal 500

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Background

SOFR is a risk-free reference rate (“RFR”) selected as the rate for usage in certain United States Dollar (“USD”) derivatives and other financial contracts, by the Alternative Reference Rates Committee (“ARRC”) of the Federal Reserve Bank of New York (“NY Fed”) in the year 2017.

It is the preferred alternative to USD LIBOR.


SOFR in Brief

SOFR is the benchmark interest rate for dollar-denominated derivatives and loans produced by the NY Fed in cooperation with the Office of Financial Research and published on each business day at 8:00 a.m. Eastern Time, tentatively. It is the measure of the cost of borrowing cash overnight collateralized by the United States Treasury securities in the repurchase option / agreement market. Since the rate is based on actual transactions unlike LIBOR settings, SOFR provides an accurate means of measuring the cost of borrowing money.


What is Term SOFR?

Fixed-income instruments including floating rate notes, loans, and mortgages are generally linked to a term rate based on tenors of 1, 3, 6 or 12 months just like LIBOR. Since SOFR is also an overnight rate, it is required to be compounded daily to get an equivalent term rate.

Term SOFR represents an indication of the forward-looking measurement of overnight SOFR, which is based on market expectations implied from derivative markets.

The ARRC has officially recommended the usage of the forward-looking SOFR term rates which are published by the Chicago Mercantile Exchange Group (“CME”) (the NY Fed’s appointed administrator).


Why Term SOFR?

  • Term SOFR is endorsed by the NY Fed, the ARRC and the Loan Syndication and Trading Association. It is recommended by ARRC as being suitable for business loan markets such as multi-lender (syndicated) facilities, middle market loans and trade finance loans where the transitioning from LIBOR to an overnight rate is difficult or impractical.
  • The rate is published on financial platforms such as Bloomberg and Refinitiv.
  • It is known by market participants at the beginning of each new interest period (i.e., Term SOFR is forward looking like USD LIBOR).
  • The applicable market conventions are broadly similar to LIBOR (for e.g.: rate setting, day count, accruals etc.).
  • Documenting the non-cumulative compounding methodology recommended by the Loan Market Association / Asia Pacific Loan Market Association for (overnight) SOFR can add around 30 pages of highly complex mathematical formulas and legal provisions to a typical loan agreement.
  • Since the CME Term SOFR reference rates are screen rates that are available on the relevant Bloomberg / Reuters page, they can be incorporated into a loan agreement in a similar manner to how legacy loan agreements incorporated LIBOR screen rates.


Disadvantages of Term SOFR

  • Term SOFR may not be as transparent as other options which adopt daily overnight rates as the term rate is based on market expectations implied by SOFR derivative contracts.
  • There is no Term SOFR available for a tenor of less than 1 month.
  • Hedging may not be the perfect option as derivative transactions typically use compounded in arrears methodology (i.e., for those using International Swaps and Derivatives Association recommended definitions, protocols and documentation). This also becomes an issue for daily simple risk-free rates. Therefore, ARRC recommends that any use of Term SOFR derivatives be limited to end-user facing derivatives intended to hedge cash products (such as loans and bonds) that reference Term SOFR.
  • Term SOFR could involve a credit adjustment spread being added to the benchmark rate (in particular for legacy loans switching to this methodology). This is because Term SOFR is a risk-free rate in comparison to LIBOR which inherently includes the credit risk of the lender along with the duration risk. A similar issue exists for daily simple and daily compounded SOFR.
  • Term SOFR can be unrepresentative or even not published on time due to the mechanics of how it is created.
  • As many banks, borrowers and other market participants have already made huge investments in methodologies using daily overnight rates, they may not be incentivized to adopt Term SOFR.


Availability of other term risk-free rates

This article does not discuss the development and use of forward-looking term rates in respect of RFRs other than SOFR. Stakeholders transitioning away from LIBOR settings in currencies other than USD, must consider the recommendations of the relevant RFR supervisory authority and working group. For instance, in the United Kingdom, the usage of term Sterling Overnight Index Average (“SONIA”) is expected to be limited. In fact, the Bank of England as well as the Financial Conduct Authority have strongly endorsed the usage of SONIA compounded in arrears for transition away from GBP LIBOR settings.



Authors:

Ankit Sinha
Partner, Juris Corp
Email: ankit.sinha@jclex.com

Akshay Kelkar
Associate, Juris Corp
Email: akshay.kelkar@jclex.com

Dhwani Bansdawala
Associate, Juris Corp
Email: dhwani.bansdawala@jclex.com

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