Term SOFR is Here - The ARRC Recommends CME Group’s Term SOFR Rates for Use
An update from the Dechert LIBOR taskforce
On July 29, 2021, the Alternative Reference Rates Committee (the “ARRC”) formally recommended the forward-looking term rates based on the secured overnight financing rate (“SOFR”) published by CME Group1 (the “CME Term SOFR Rates”), clearing the way for use of CME Term SOFR Rates in many cash products and some related derivatives, as well as for the purpose of measuring the performance of an investment fund.
Although the CME Term SOFR Rates have been available for use since April 2021,2 the formal recommendation of the CME Term SOFR Rates by the ARRC, taken together with several other recent developments,3 marks the completion of the final steps in the ARRC’s paced transition plan aimed at encouraging adoption of SOFR and SOFR-based rates. The CME Term SOFR Rates are designed to meet the International Organization of Securities Commissions (“IOSCO”) Principles for Financial Benchmarks4 and are compliant5 with the European Union Benchmark Regulation6 (“EU BMR”) and the United Kingdom Benchmark Regulation7 (“UK BMR”), thus permitting their “use” (as defined in the EU BMR and the UK BMR)8 by those who are required to comply with these Regulations.
About the Recommended Rates
The CME Term SOFR Rates9 are intended to provide a robust measure of forward-looking SOFR term rates, based on market expectations implied from transactions in the derivatives markets. The methodology for determining CME Term SOFR Rates uses a combination of SOFR overnight indexed swaps (OIS) and one-month and three-month SOFR futures contracts, the latter being based on executed and executable bids and offers in the applicable SOFR futures contracts, such as those traded on a CME Group Designated Contract Market.10 The administrator of the CME Term SOFR Rates is CME Group Benchmark Administration Limited, which is registered as a benchmark administrator pursuant to the UK BMR and is regulated by the Financial Conduct Authority (the “FCA”) in the United Kingdom.11 CME Group’s proposal for its term SOFR rates was selected at the end of a request for proposal process commenced by the ARRC in September 2020.12 Currently, the CME Term SOFR Rates are calculated and published for 1-month, 3-month and 6-month tenors. CME Group has indicated that, before the end of 2021, it intends to launch a 12-month CME Term SOFR Rate which complies with the IOSCO Principles for Financial Benchmarks, the EU BMR and the UK BMR; launch of this additional term SOFR rate is dependent on its approval by the independent oversight committee which oversees the production of the CME Term SOFR Rates.
The ARRC’s recommendation is the culmination of a multi-year process to move market participants away from USD LIBOR.13 Even though the ARRC and members of the official sectors in the U.S. and the U.K. have stated that their desire is for adoption of SOFR-based rates in USD-denominated cash products, widespread adoption in the market has been slow. Although a recommendation from the ARRC was not a requirement (in the U.S. or elsewhere) for market participants to use SOFR or term SOFR rates, the ARRC’s recommendation makes broad adoption of the CME Term SOFR Rates easier, particularly for regulated entities in the U.S., the U.K. and the E.U. The CME Term SOFR Rates may also help market participants to meet supervisory guidance from U.S. banking regulators that effectively precludes the use of most USD LIBOR rates14 in new transactions after the end of 2021.
Recommended Best Practices for Using CME Term SOFR Rates in New Contracts
The ARRC’s formal recommendation of CME Term SOFR Rates follows its announcement on July 21, 2021 of conventions and recommended best practices for the use of the CME Term SOFR Rates.15 In its statement of recommended best practices,16 the ARRC confirmed that it continues to recommend as a general principle that all market participants use overnight SOFR and SOFR averages,17 given the robustness and reliability of these rates. However, the ARRC also indicated its support for the use of the CME Term SOFR Rates in areas where use of overnight or averages of SOFR has proven to be difficult, noting that CME Term SOFR Rates will be especially helpful for the business loans market, particularly multi-lender facilities, middle market loans and trade finance loans, and the ARRC’s statement also recognized that the use of the CME Term SOFR Rates may be appropriate for securitizations of underlying assets that use a CME Term SOFR Rate. Other loan and cash products not specifically mentioned, such as commercial mortgage loans, could also use the CME Term SOFR Rates rather than other SOFR-based alternatives, but the statement of best practices confirms that the ARRC does not support the use of the CME Term SOFR Rates for “the vast majority” of derivative products (noting the importance to financial stability of transitioning the derivatives markets to overnight risk-free rates), and limits its recommendation to “end-user”18 facing derivatives intended to hedge cash products that use the CME Term SOFR Rates.
The CME Term SOFR Rates are available to be licensed in cash market transactions and securitizations of underlying assets that use the CME Term SOFR Rates, at no cost until the end of December 2026. CME Group has indicated that its license will be expanded to include derivatives that hedge cash instruments linked to the CME Term SOFR Rates to be consistent with ARRC recommendations. CME Group has also stated that licensing for permissible derivatives will be available on a market standard pricing schedule at a cost that is consistent with U.K. FRAND (fair, reasonable, and non-discriminatory) principles.
Use of the CME Term SOFR Rates in Contractual Fallbacks
The recommendation by the ARRC of the CME Term SOFR Rates also presumably allows the first step of “Term SOFR”19 in the priority of fallbacks from USD LIBOR in the ARRC’s recommended contract language to be used for business loans, syndicated loans, floating rate notes and securitizations.20 As used in those recommendations, Term SOFR means a forward-looking term SOFR for the applicable “Corresponding Tenor” (meaning a period equivalent to the replaced USD LIBOR tenor, for example, 1-month USD LIBOR to the 1-month CME Term SOFR Rate or 3-month USD LIBOR to the 3-month CME Term SOFR Rate) that has been selected or recommended by any of the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York (the “FRBNY”), or a committee officially endorsed or convened by any of the foregoing, including the ARRC.
On the other hand, there may be some variation in contract language which prevents automatic adoption of the CME Term SOFR Rates. Some contracts using provisions that are similar to ARRC-style fallback language may include additional requirements before a forward-looking term SOFR rate can be adopted — for example, the requirement that the use of Term SOFR is administratively feasible or is consistent with industry accepted practices. Furthermore, as a result of benchmark replacement retesting features (also called a “Term SOFR Transition Event” or a “flip forward”) in some contractual fallback language (including as optional language in the ARRC’s recommended fallback language for securitizations), some cash products that have already transitioned from USD LIBOR to some other forms of SOFR may have a second transition to a CME Term SOFR Rate.
LIBOR Replacement Legislation
For contracts governed by New York law, the ARRC has indicated that the CME Term SOFR Rates will likely be the statutory USD LIBOR replacement rates for cash products that lack effective fallback provisions for purposes of the New York State law on USD LIBOR discontinuance.21 It is not certain whether pending federal legislation on USD LIBOR discontinuance22 will also result in the CME Term SOFR Rates being selected as the statutory USD LIBOR replacement for contracts that may transition under that legislation. Under principles of English private international law applicable to the law of contract, the laws of a jurisdiction other than England ordinarily have no effect on contracts governed by English law; therefore, neither U.S. federal nor New York state legislation is likely to affect bonds (including securitized bonds), loan agreements, other cash products and fund documents referencing USD LIBOR that are governed by English law. The parties to bonds, loan agreements, other cash products and fund documents governed by English law (or, indeed, any law other than the laws of a U.S. state) should continue to seek to amend these contractual arrangements on a voluntary basis where possible.23
Using the CME Term SOFR Rates
The ARRC’s recommended conventions for the use of the CME Term SOFR Rates are similar to current market practices for using USD LIBOR. This consistency means that transitioning from USD LIBOR to the applicable corresponding CME Term SOFR Rate will require relatively few structural changes to the interest accrual mechanics in affected contracts compared to a transition to other forms of SOFR.
A few differences, however, include that USD LIBOR is determined on London business days24 and that the CME Term SOFR Rates are calculated for each day on which the FRBNY calculates and publishes SOFR, which is generally on “US Government Securities Business Days."25 As the CME Term SOFR Rates are forward-looking term rates, the ARRC recommended that the “determination date” for the CME Term SOFR Rates be two US Government Securities Business Days prior to the first day of the related interest accrual period, while the determination date for USD LIBOR is generally two London business days prior to the first day of the related interest period. Many financial contracts referencing USD LIBOR included a polling requirement or a lookback to the “last available USD LIBOR” if USD LIBOR was temporarily unavailable. The ARRC recommended conventions include a lookback to the “last available CME Term SOFR Rate” but only to the extent that the lookback is to a setting of a CME Term SOFR Rate that is not more than three US Government Securities Business Days prior to the applicable determination date. In addition, permanent fallbacks may be applicable if a CME Term SOFR Rate is not available within the recommended lookback window. The ARRC has recommended that instruments referencing a CME Term SOFR Rate include robust contractual fallback language, such as language modeled after the ARRC’s recommendations.26 Supervised entities subject to compliance with the UK BMR or the EU BMR are required, in any event, by these Regulations to have robust written plans in place specifying alternative benchmarks to apply in the event of the discontinuance of a referenced benchmark.
Availability of Other Term Risk-Free Rates
This note does not discuss the development and use of forward-looking term rates in respect of risk-free rates (“RFRs”) other than SOFR. Market participants transitioning away from LIBOR settings in currencies other than USD, however, must give consideration to the recommendations of the relevant RFR supervisory authority and working group. In the U.K., use of term Sterling Overnight Index Average (“SONIA”) is expected to be limited. The Bank of England and the FCA have strongly encouraged use of SONIA compounded in arrears for transition away from GBP LIBOR, and to date, most contracts transitioning away from GBP LIBOR, and almost all new floating rate GBP loan and bond documentation entered into since April 2021, have adopted SONIA compounded in arrears. Most recently, in late July the FICC Market Standards Board published its finalized “Standard on use of Term SONIA Reference rates”27 – the standard provides the context around expected use of term SONIA and sets out key principles with respect to the anticipated limited use cases where there may be a “robust rationale” for using term SONIA reference rates.
3) These developments include the ARRC’s selection of CME’s proposal at the end of the Term SOFR RFP process, the release by the ARRC of recommended best practices for scope of use and recommended conventions.
6) Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds, etc., as amended.
7) The EU Benchmark Regulation as implemented into the laws of the United Kingdom pursuant to the European Union (Withdrawal) Act 2018 and as amended by the Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019 (S.I. 2019/657) and the Financial Services Act 2021.
8) “Use”, as defined in the EU BMR and the UK BMR, includes the use of a benchmark to measure the performance of an investment fund through an index or a combination of indices for the purpose of tracking the return of such index or combination of indices, of defining the asset allocation of a portfolio, or of computing performance fees, as well as “use” in the context of the issuance of a financial instrument which references an index/benchmark, the determination of the amount payable under a financial instrument or financial contract, and providing a borrowing rate calculated as a spread or mark-up over an index or combination of indices.
11) The CME Term SOFR Rates are, therefore, “third country” benchmark rates for the purposes of the EU BMR, and currently benefit from the transition period provided for pursuant to the EU BMR for “use” of benchmarks administered by a U.K.-regulated benchmark administrator.
14) See, e.g., https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20201130a1.pdf, https://www.federalreserve.gov/supervisionreg/srletters/SR2107a1.pdf and https://www.federalreserve.gov/supervisionreg/srletters/SR2107a2.pdf. In addition to the guidance of the US banking and financial services regulators strongly discouraging the use of USD LIBOR tenors after the end of 2021, the FCA could prohibit some or all new “use” of USD LIBOR tenors by U.K.-regulated persons pursuant to its powers under the UK BMR, and the European Commission could, likewise, prohibit the “use” of USD LIBOR tenors by E.U.-regulated persons pursuant to its powers under the EU BMR.
17) The SOFR Averages published on the website of the FRBNY are compounded averages of SOFR calculated over rolling 30-, 90- and 180-calendar day periods. See https://www.newyorkfed.org/markets/reference-rates/sofr-averages-and-index.
18) The definition of “end-user” here is not entirely clear. At a minimum, the ARRC likely intends “end-user” to include those seeking interest rate caps on cash products linked to the CME Term SOFR Rates. The ARRC is expected to clarify the meaning of “end-user” in its recommendation soon.
19) As used in this section, Term SOFR refers to the rate in the ARRC’s recommended fallback language.
23) The FCA is continuing to consult on the criteria it will apply in order to categorize contracts or types of contracts as “tough legacy”, thus permitting “synthetic LIBOR” to continue to be “used” in these contracts by U.K.-regulated persons, in accordance with the UK BMR, for a certain (currently undesignated) period of time. No reliance should be placed on a particular contract being categorized as “tough legacy”; and not all financial products are covered, in any event, by the “use” concept specified in the UK BMR or the EU BMR. The message from the FCA continues to be: continue to strive to amend all LIBOR-linked contracts, irrespective of the currency, on a voluntary basis as much as possible, and do not rely on the potential availability of statutory solutions.
24) Generally, any day (other than a Saturday or a Sunday) on which banks and foreign exchange markets are open for business in London.
25) The ARRC recommended a definition of “US Government Securities Business Day” which includes any day except for a Saturday, Sunday, a day on which the Securities Industry and Financial Markets Association (“SIFMA”) recommends that the fixed income departments of its members be closed for the entire day for purposes of trading in U.S. governmental securities based on the SIFMA calendar, but the SOFR Administrator (currently the FRBNY) may, from time to time, designate other days on which SOFR will not be published.
26) The updated bilateral business loan and syndicated business loan recommendations from the ARRC include post-LIBOR versions of ARRC recommended language. See https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/arrc-supplemental-hardwired-recommendation.