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Investor insights 21 September 2021

Formal recommendation of SOFR Term Rates

With only a few months to spare until the cessation deadline for new contracts referencing USD LIBOR, the ARRC has formally recommended the CME Group’s forward looking SOFR term rates, thus realizing a major transition milestone.

For a brief overview of the SOFR term rate, its available tenors and how to access it, please consult our previous communication in this regard.

This formal recommendation was made possible through the uptick in SOFR liquidity that resulted from the change in interdealer trading conventions under the aptly titled “SOFR First” initiative. The SOFR First recommendations adopted by US authorities represent a prioritization of trading in SOFR rather than LIBOR, and supported the necessary conditions for increased  SOFR liquidity, which in turn contribute to a more robust SOFR term rate (as the rate is based on the underlying SOFR futures market).

The availability of a SOFR term rate is a particularly significant development for cash markets, which struggled to adapt to overnight rates, and thus lagged in overall transition readiness. Very importantly, when the formal endorsement was announced, the ARRC did indicate its support for the use of the SOFR term rate for business loan activity (particularly multi-lender facilities, middle market loans and trade finance) and certain securitizations that hold underlying business loans or other assets that reference the SOFR term rate. The ARRC did however emphasis that it does not support the use of the SOFR term rate for the vast majority of derivative markets. Specifically, it stated that use of SOFR term rates in derivatives markets should be limited to “end-user facing derivatives intended to hedge cash products that reference the SOFR Term Rate”.

On 27 August 2021, the Alternative Reference Rates Committee (a group of private-market participants convened to help ensure a successful transition from USD LIBOR) published Frequently Asked Questions on Best Practice Recommendations Related to Scope of Use of the Term Rate, which can be accessed here.

In that document, the ARRC reiterated its previous recommendations that overnight SOFR and SOFR averages remain the preference for all products, and that the use of the term rate should be limited to certain cash market instruments and derivatives used to hedge those instruments. According to the ARRC the interdealer market should not trade SOFR term rate derivates, as its considers that dealers can “warehouse” any risks they face from trading term SOFR derivatives with end users  through effectively managing their basis risk. In other words, dealers facing end users on term SOFR derivative instruments should not seek to hedge their resulting term rate exposure with an additional SOFR term rate derivative. For other lending institutions not making two-way prices or market making, this use of the SOFR term rate would be aligned with ARRC guidance.

Whilst the ARRC did provide insight into its recommend uses of the term rate, it also specified that ultimate adoption of these recommendations by market participants is voluntary. It thus remains to be seen how the market chooses to interact with these rates, as well as how supervisory expectations will develop over time. With the LIBOR cessation deadlines fast approaching, there will no doubt be numerous developments and emerging practices in the coming months. As with all such developments, we advise market participants to keep a close eye on the changes and take the necessary steps to understand the impact on their operations. Standard Bank is taking the necessary steps to ensure that we keep up to date with all LIBOR developments, including operationalizing the ability to trade term SOFR in line with the official recommendations as these develop.