Term SOFR: Context and Latest Developments for US Dollar Lending in the UK

The transition away from LIBOR to SOFR has progressed strongly in the year of 2022. Based on the data shared by the Alternative Reference Rates Committee (ARRC) at its meeting on September 8, 2022,¹ SOFR is now the predominant rate across the US cash and derivatives markets. The next significant milestone for the US dollar LIBOR transition will be 30 June 2023 on which²: 

• the one-month, three-month, and six-month US dollar LIBOR settings will no longer be representative of the underlying market and that representativeness will not be restored; and
• publication of the overnight and twelve-month US dollar LIBOR settings will permanently cease.

Term SOFR has played an important role in US dollar LIBOR Transition, and many market participants predict a further uptake of Term SOFR in the loan and other cash markets.

Term SOFR: establishment of a benchmark rate

21 May 2021. ARRC announced that it had selected CME Group Benchmark Administration Limited (CME) as the administrator for a forward-looking Secured Overnight Financing Rate (SOFR) term rate. At that stage, ARRC postponed its formal recommendation of the CME Term SOFR rates until market indicators for the term rate have been met.

21 July 2021. With just five months until no new LIBOR, ARRC announced conventions and recommended best practices for the use of SOFR Term Rates.³

29 July 2021. ARRC formally recommended CME which started publishing one-month, three-month and six-month Term SOFR Reference Rates. This announcement was important in the context of the ARRC’s fallback language for legacy contracts which lists as the first waterfall option “the forward-looking term rate based on SOFR that has been selected or recommended by the Relevant Governmental Body.”

15 September 2021. The Working Group on Sterling Risk-Free Reference Rates (Sterling Working Group) stated that “the ARRC’s recommended best practice for term SOFR would be relevant for US dollar business in London, while the somewhat narrower term SONIA use cases identified by the FICC Markets Standards Board (FMSB) and the Sterling Working Group would remain the relevant reference points for sterling.” Recommendations for the use of Term SOFR Rates issued by ARRC and Sterling Working Group are discussed in more detail below.

19 May 2022. As a result of the twelve-month CME Term SOFR tenor coming online and the related underlying derivatives markets becoming sufficiently mature, ARRC unanimously endorsed the use of CME twelve-month Term SOFR.

How CME Term SOFR Reference Rates work?

The CME Term SOFR Reference Rates benchmark is a daily set of forward-looking interest rate estimates, calculated and published for one-month, three-month, six-month and twelve-month tenors. CME Term SOFR Reference Rates are calculated using data from CME SOFR future contracts to determine volume weighted average prices. These are then used in a projection model to determine CME Term SOFR Reference Rates. Publication of CME Term SOFR takes place on day T based on data sampling on T-1. The start date of the reference period for the Term SOFR rates is T+2. In accordance with the recommended SIFMA US Holiday Schedule, data sampling and publication can only take place on a Business Day.

The CME Term SOFR Rates are designed to meet the International Organization of Securities Commissions Principles for Financial Benchmarks and be compliant with the European Union Benchmark Regulation (EU BMR) and the United Kingdom Benchmark Regulation (UK BMR). As a result, their “use” (as defined in the EU BMR and the UK BMR) is permitted by those who are required to comply with these regulations. 

CME as an administrator of the CME Term SOFR Rates is registered as a benchmark administrator pursuant to the UK BMR⁴ and is regulated by the Financial Conduct Authority in the United Kingdom.

Any institution that uses CME Term SOFR Reference Rates as a data input or reference in valuation, pricing, transactional or benchmarking activities should obtain a use license from CME. It is not sufficient simply to have a license with Bloomberg, Refinitiv or another distributor or receive information from a third party like a trustee. In some cases more than one type of license may be required to cover the activities of a market participant. For example, uses of CME Term SOFR in cash market financial products (e.g., in a CME Term SOFR referencing loan) and in derivative products (e.g., in a swap linked to the same lender and/or in hedging instrument for the same CME Term SOFR referencing loan by an end user) should be covered by each transactional party by different categories of licenses. In case of syndication, each party on the lender side requires a license to use CME Term SOFR as an input or reference to a loan. However, an end user does not require a license by merely being a borrower or counterparty to a loan transaction as long as it is not involved in the management of investment portfolios (such as calculation and/or reconciliation of interest) with assets priced using CME Term SOFR and/or provide a subsequent intercompany loan referencing the CME Term SOFR. Therefore, market participants should carefully assess their  activities which have exposure to the CME Term SOFR Reference Rates and procure all relevant licenses for such activities. At present and until the end of 2026, there is no cost for a CME Term SOFR license for cash products.

Term SOFR Rules: UK and US markets

As we mentioned above, following recommendations of the CME Term SOFR and publication of conventions and best practices for its use by ARRC, in September 2021, the Sterling Working Group concluded that such practices could be used by US dollar business in London. At the same time, in the view of the Sterling Working Group, the guidance “should be followed for each currency respectively including in multi-currency facilities, and for sterling markets, compounded in arrears SONIA would be the most robust rate.”⁵ This position of the Sterling Working Group is broadly aligned with the ARRC’s guidance, which as a “general principle recommends that market participants use overnight SOFR and SOFR averages given their robustness, particularly in markets where we have seen that there can be successful adoption of these rates.”⁶ However, with respect to new contracts, the ARRC supports the use of the CME Term SOFR Rate in areas where the use of overnight and averages of SOFR has proven to be difficult. Multi-lender facilities, middle market loans and trade finance loans are specifically mentioned by ARRC as business loans where transitioning from LIBOR to an overnight rate may require the use of the SOFR Term Rate. In ARRC’s view, a similar approach could also be appropriate for “certain securitizations that hold underlying business loans or other assets that reference the SOFR Term Rate and where those assets cannot easily reference other forms of SOFR.” Finally, ARRC recognises that in limited circumstances the SOFR Term Rate could be used in the end-user facing derivatives intended to hedge cash products that reference the SOFR Term Rate.

Even in the context of a cautious approach towards the use of Term SOFR in the UK market, in response to demands from market participants in October 2021, LMA published its first exposure draft incorporating Term SOFR for use in developing market jurisdictions (DM Exposure Draft). On 10 October 2022, LMA updated its DM Exposure Draft and produced a new draft using Term SOFR for investment grade loans (IG Exposure Draft, and together with the DM Exposure Draft, LMA Term SOFR Exposure Drafts).

New key developments in LMA Term SOFR Exposure Drafts

ICE Term SOFR. Since the CME Term SOFR has been endorsed by ARRC, LMA Term SOFR Exposure Drafts continue to regard CME Term SOFR as the primary basis to calculate interest for loans denominated in US dollars. In parallel, LMA Term SOFR Exposure Drafts have introduced the ICE Term SOFR as a new fallback for CME Term SOFR.

The ICE Term SOFR Rates were launched by ICE Benchmark Administration Limited (IBA) on 16 March 2022. The ICE Term SOFR rates are designed to measure, on a daily basis, forward-looking SOFR rates over one, three, six and twelve month tenor periods. At present, ICE Term SOFR settings are calculated using input data of dealer-to-client prices and volumes for SOFR-linked interest rate swaps. If such input data is insufficient, futures settlement prices in respect of designated contracts referencing SOFR could be used to calculate ICE Term SOFR settings.⁷ As with the CME Term SOFR, those market participants who consider using the ICE Term SOFR should procure the relevant license(s). The fees payable in respect of an ICE Term Reference Rates usage license are currently being waived by IBA until 2023.

At this moment there is no statement by IBA as to when the relevant tenor for each ICE Term SOFR begins in relation to its publication day. LMA Term SOFR Exposure Drafts follows International Swaps and Derivatives Association (ISDA) approach providing that the relevant tenor for ICE SOFR begins two US Government Securities Business Days following publication.

The market participants need to assess their operational capabilities to use ICE Term SOFR and bear in mind that whilst CME Term SOFR and ICE Term SOFR are designed to measure the same underlying interest, such rates are not the same as they are calculated using different methodologies and data inputs. As it currently stands, LMA Term SOFR Exposure Drafts do not address any differences between such rates.

Credit Adjustment Spread (CAS). An option to specify the use of CAS as part of the day-one pricing metric for SOFR Term Loans is included in both LMA Term SOFR Exposure Drafts. The new technicality is that in the IG Exposure Draft, CAS is defined as Term Reference Rate CAS and referred to in the body of the document (section 11.1 (Calculation of interest – Term Rate Loans)) and then in a separate schedule dealing with interest rate provisions. Notwithstanding the terminology and structure of the two documents, the general approach to CAS remains the same: “the commercial choice to be made is one of presentation and the foundation basis of a loan based on CME Term SOFR.”⁸ Therefore, based on the context of each transaction, the interest rate for a Term SOFR Loan from the outset could be structured as Term SOFR plus margin or Term SOFR plus margin and plus CAS, where CAS could be set for all tenors or on a per tenor basis. Finally, CAS is discussed further below in the context of particular fallbacks.

Short-term and temporary unavailability fallbacks. LMA Term SOFR Exposure Drafts still include only illustrative drafting on these matters due to the “lack of established market practice and consensus as to the most appropriate fallbacks to CME Term SOFR.”⁹ The current fallbacks’ structure follows the waterfall used in the LMA Developing Markets Documents and the existing term rate framework of the LMA Multicurrency RFR Documents. This approach also has its roots in an optional waterfall language developed by LMA for its LIBOR documentation and the relevant steps include: interpolation of CME Term SOFR → shortened Interest Periods and the use of historic CME Term SOFR → shortened Interest Periods and the interpolated historic CME Term SOFR.

The market practice of applying such a waterfall both in legacy LIBOR and in new Term SOFR transactions (except for the interpolation step) is limited. Even the use of interpolation is dependent upon the operational capabilities of a particular lender or administrative agent. It presents further challenges if the parties are required to interpolate two rates which are constructed on different bases: in relation to Interest Periods of less than one month, interpolation should be between overnight SOFR administered by the NY Fed and one month CME Term SOFR published by CME.

The proposed waterfall differs from the ARRC’s conventions for syndicated and bilateral business loans¹⁰ and ISDA’s Supplement 84 to the 2006 ISDA Definitions¹¹ referring to a “last published fallback,” i.e., the Term SOFR rate for the applicable tenor most recently published by CME as administrator provided that such rate is not more than three US Government Securities Business Days prior to the date as of which the fallback applies. In comparison, ISDA’s Supplement 84 does not include a limit on the “last published” date. As a result, for transactions structured using LMA Term SOFR Exposure Drafts, a potential basis risk exists between the temporary fallbacks (as well as permanent fallbacks reviewed below) to the loan and derivatives related to such loan which needs to be carefully considered by market participants and their advisers.

The previous DM Exposure Draft did not include any drafting options for fallbacks for the permanent cessation of Term SOFR. However, the commentary to the previous DM Exposure Draft outlined some suggestions, including “last reset” (i.e., Term SOFR as calculated for the immediately preceding interest period) and “last recent” (i.e., Term SOFR as calculated for a recent reference period which is shorter than that of the relevant interest period). In some transactions these options could be seen together with linear interpolation and “last published” as alternatives to the temporary fallbacks in the LMA Term SOFR Exposure Drafts.  

In the current DM Exposure Draft ICE Term SOFR → Interpolated ICE Term SOFR → Fixed Central Bank Rate are included as fallbacks for long-term unavailability or permanent discontinuation of all tenors. The Central Bank Rate (either prevailing at the beginning of the relevant Interest Period or a more historic Central Bank Rate) is fixed at the beginning of the Interest Period and therefore does not reflect any subsequent changes in the level of the Central Bank Rate during the relevant Interest Period. To address this the market participants may consider shortening the Interest Period in order to minimize the length of time for which the fixed Central Bank Rate is used before its new fixing.

The IG Exposure Draft differs from the DM Exposure Draft to the extent that if ICE Term SOFR is not selected as the Alternative Rate or if such Alternative Rate is not available, it offers mutually exclusive alternatives — the fixed Central Bank Rate (as described above) or compounded overnight SOFR (or if an overnight SOFR is unavailable, a compounded daily central bank rate). Needless to say, if the latter is chosen the parties would have to apply compounding methodology for their fallback. A compounded in arrears rate is not known in advance and therefore may not provide borrowers with sufficient notice of the amount of interest payable. It also presents some  operational challenges. As a result, the compounded overnight SOFR is not proposed in the DM Exposure Draft and appears only in the IG Exposure Draft.

The definition of “Central Bank Rate” proposed in the LMA Term SOFR Exposure Drafts refers to the short-term interest rate target (or the mid-point of any target range) set by the US Federal Open Market Committee published by the Federal Reserve Bank of New York for the relevant day. In parallel, the Federal Reserve Bank of New York also publishes other reference rates based upon transactions in the money markets, including the Effective Federal Funds Rate and the Overnight Bank Funding Rate. As a result, market participants have an option to include these alternative reference rates for use instead of, or in parallel with the short-term interest rate target set by the US Federal Open Market Committee.

For the purposes of the fixed Central Bank Rate fallback the definition of “Quotation Day” includes a separate limb which specifies the day on which the level of the central bank rate should be determined. It envisages that this day may be different from the Quotation Day used for CME Term SOFR. A market practice override which applies to the Quotation Day used for CME Term SOFR and ICE Term SOFR is not relevant to central bank rates and therefore is missing from that separate limb in the definition of “Quotation Day.”

LMA Term SOFR Exposure Drafts provide an option to add a specified adjustment spread to the central bank rates used in place of CME Term SOFR. This is to address any potential difference between CME Term SOFR and the specified central bank rate. Depending on the structure of any particular transaction, the use of such a spread and how it could be defined should be determined on a case by case basis by transaction parties. It is worth noting that in contrast with central bank rates and relevant spread adjustments the IG Term Exposure Draft does not seek to make an adjustment to take account of any potential difference between CME Term SOFR and compounded overnight SOFR. Market participants should bear in mind that Fallback CAS in this context is solely to replace the Term Reference Rate CAS (if any) which may apply with respect to CME Term SOFR as part of the pricing metric for Term Rate Loans.

Finally, LMA Term SOFR Exposure Drafts retained optional concepts of “cost of funds,” “break costs” and “market disruptions.” It is an open question whether the concept of “cost of funds” as the “ultimate” fallback in the LMA Term SOFR Exposure Drafts could be a useful solution for market participants. Cost of funds (together with break costs and market disruption concepts) would be applicable if lenders match their funding on a Term SOFR basis for the purposes of their participation in the relevant Term SOFR loan. In other words, the pricing would be made on the basis of a benchmark, which is an estimate of the lenders’ cost of funds plus margin. In current markets, funding sources vary and cannot or do not intend to match the lenders’ participation in Term SOFR loans. As a result, in the context of the LMA Term SOFR Exposure Drafts, Term SOFR does not necessarily have a connection to lenders’ cost of funds and therefore such a concept would not be the appropriate fallback.

Whilst some operational, structuring and drafting issues for Term SOFR loans remain unsettled, the recent publication of the LMA Term SOFR Exposure Drafts clearly suggests that the use of Term SOFR for US dollar lending is an attractive option for market participants in the UK. In light of these new documentary forms, some guidance from the Sterling Working Group and ARRC’s best practice recommendations, the use of Term SOFR looks set to continue its expansion in the UK market.   
 

¹ ARRC September 8 Meeting Readout. https://www.newyorkfed.org/arrc/index.html.

² The Financial Conduct Authority (FCA) announcement dated 5 March 2021 on future cessation and loss of representativeness of the LIBOR benchmarks. https://www.fca.org.uk/news/press-releases/announcements-end-libor. The FCA has powers to require the continued publication on a synthetic basis of the one-month, three-month and six-month US dollar LIBOR settings for a further period after end-June 2023, taking into account views and evidence from the US authorities and other stakeholders. The FCA is still to announce the outcome of its consultations regarding continued publication of US dollar LIBOR on a synthetic basis when the US dollar LIBOR panel ends. Therefore, there is no certainty if any of these settings will remain in place after June 30, 2023.

³ https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/ARRC_Scope_of_Use.pdf.

⁴ As stated on its website, the CME Group is committed to ensuring that CME Term SOFR continues to be available for use as a benchmark in the EU post-transition. The exact approach to achieve it is still to be confirmed by CME.

⁵ https://www.bankofengland.co.uk/minutes/2021/september/rfr-september-2021.

⁶ https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/ARRC_Scope_of_Use.pdf.

⁷ https://www.theice.com/iba/term-rates.

⁸ Term SOFR Commentary dated October 2022 as published by LMA on its website https://www.lma.eu.com.

⁹ Term SOFR Commentary dated October 2022 as published by LMA on its website https://www.lma.eu.com.

¹⁰ Forward Looking Term SOFR and SOFR Averages (Applied in Advance) Conventions for Syndicated and Bilateral Business Loans published by ARRC on 21 July 2021 on its website https://www.newyorkfed.org/arrc/announcements.

¹¹ Published and effective on 8 September 2021.