Forward SOFR, the forward-looking forward rate based on the Secured Overnight Funding Rate (SOFR), has become an established benchmark rate for new US dollar loans in the US syndicated loan market.
Despite this, its use in the European syndicated loan market remains very limited, where the SOFR capitalized in arrears methodology is mainly used for US dollar loans. There are a few barriers to using the term SOFR in European markets, not the least of which is the lack of clear industry or regulatory guidance in the UK and Europe, but recent trends suggest that the use of the term SOFR will soon become more widespread. .
What rules apply?
The Joint Dear CEO letter from the Financial Conduct Authority and the Prudential Regulation Authority of March 2021 provided that market participants should use the most robust alternative rates taking into account relevant industry guidelines and recommendations. Following the recommendation of the US Alternative Reference Rates Committee (ARRC) of CME Group’s Term SOFR in July 2021At the September 2021 meeting of the GBP Risk-Free Reference Rates Working Group (£WG), £WG members noted that the ARRC’s recommended best practice for forward SOFR would be relevant to US dollar transactions in London. This suggests that despite the current market practice of using compound overnight rates in arrears, forward SOFR may be adopted in UK markets in situations where it follows US recommendations. Although the ARRC recommends “as a general principle” that market participants use SOFR and SOFR day-to-day averages Given that these are the most robust benchmark rates, the ARRC supports the use of the term SOFR “for corporate lending activities – particularly multi-lender facilities.” This industry orientation has manifested itself in industry practice, as US syndicated loans typically use the term SOFR as the benchmark rate.
The minutes of the £WG meeting go on to say that “[g]guidance should be followed for each currency respectively, including in multi-currency facilities”. This means that while compounded arrears is the clear approach for sterling syndicated loans, the door seems to be open to using alternative approaches for other currencies.
Despite this, a number of additional factors have made European lenders reluctant to use the term SOFR:
- Contrasting guidance on the use of forward rates: Contrary to ARRC recommendations for US dollar lending, the £WG position supported by UK regulators is that the SONIA term, the equivalent forward-looking forward rate for the pound sterling, should only be used in a very narrow setting. set of circumstances where a forward-looking rate is needed, such as emerging markets, Islamic financing, or where certainty of an interest rate up front is a key consideration, such as retail borrowing. This firm position against the use of forward rates more broadly and the relatively scant advice from regulators or task forces on what conventions to use in relation to currencies outside that regulator’s jurisdiction has arguably made UK and European lenders more cautious about using the term SOFR.
- Documentary inertia: The vast majority of new risk-free loans in the European syndicated market follow the wording and covenants contained in Loan Market Associations (LMA) recommended form agreements. The LMA uses a capitalized approach to arrears for legacy LIBOR currencies and generally followed the £WG recommendations for the pound, even in a multi-currency environment. This one-size-fits-all approach has taken root in European markets and, as noted below, there are a number of documentary issues in a multi-currency context regarding the implementation of the SOFR term for US Dollars that have yet to be resolved.
- Operational Constraints: Following £WG recommendations not to lend new sterling LIBOR loans after Q1 2021, sterling-exposed lenders had already built their operating infrastructure on the basis of risk-free rates compounds before there was any certainty. A term SOFR would be recommended. in the USA. Even after the Term SOFR was recommended, European markets continued to use the backlog SOFR and some institutions may not have the operational capability or authorization to use the Term SOFR. Therefore, even when some lenders in a consortium are ready for term SOFR (typically US banks), other lenders may not be operationally ready to use the rate at this point.
SOFR implementation term
For participants in Europe intending to use Term SOFR, the primary guidance material is the LMA’s Exposure Draft (the Exposure Draft) on the Use of Term SOFR in Developing Markets. While this document is helpful in bringing the SOFR to term in a form familiar to participants in the European syndicated loan markets (as opposed to the document forms used in the US markets), the Exposure Draft is not a conclusive statement on the how to implement the rate and leaves open a number of unresolved points:
- Fallbacks – The Exposure Draft largely replicates the cascade of fallbacks applicable under the LMA documents for the temporary unavailability of EURIBOR (or LIBOR); i.e. interpolation, shortened interest period and historical rate, etc. However, this waterfall is incomplete as it does not predict long-term pullbacks and the short-term pullbacks that are included are for illustrative purposes only rather than reflecting market practice. Also, since the shortest published duration for the SOFR term is one month, there are issues with interpolation for durations less than one month. In the United States, if forward SOFR were to cease or become unrepresentative, loans would generally apply either a hardwired option to simple daily SOFR or an amendment approach that allows the borrower and agent to determine the rate and spread adjustment which is based on market rates and recommendations of relevant government authorities with a negative consent right from a required number of lenders.
- Disruption Costs, Market Disruption, and Cost of Funds – The LMA notes that each of these concepts is underpinned by the fundamental premise that lenders are expected to fund their participation in a facility over time and the price based on an index benchmark which is an approximation of the lenders likely cost of funds plus a margin. There would therefore be an argument that such concepts are irrelevant in today’s markets where banks fund themselves from a variety of sources and where counterpart funding is not necessarily feasible or desirable. The shift from LIBOR to risk-free rates (whether applied in arrears or as a forward rate) further erodes the idea that the benchmark interest rate is an approximation of the true cost of funds for a lender, because the risk-free rates have no relation to the lenders’ cost of funds.
- Hedging – Particularly relevant for more structured finance such as project finance or real estate loans is the ability for borrowers to obtain interest rate hedging. Although the ARRC has generally advised against the use of SOFR futures in derivatives, it does allow such products where the benefit is for an “end user”, i.e. the borrower who has exposure to the products. term SOFR cash flow.. Since the guidelines only allow hedging agreements with an “end user”, hedging counterparties must not enter into back-to-back agreements that reference forward SOFR and must bear the basis risk of hedging their own exposure using day-to-day SOFR-based products. Liquidity is lower in the forward SOFR derivatives market compared to the overnight market, which may result in higher costs to obtain cover. Borrowers may prefer to use compound SOFR for their loans to benefit from the lower costs and greater liquidity in this derivatives market. Parties should also consider the degree of basis risk that may arise due to the differences between the temporary and permanent fallbacks contained in the ISDA definitions and the fallbacks set out in the loan agreement.
While some regulated entities may continue to view the use of the term SOFR with caution without a definitive statement from UK or EU regulators, current UK guidance appears to suggest that participants may adopt this rate for US dollar lending in accordance with the recommendations of ARRC best practices. . Documentary and operational challenges remain, but they are not insurmountable.
“Benchmark rate use cases: compounding in arrears, forward rates and other alternatives” https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/use-cases -of-benchmark -compound-rates-in-arrears-forward-rates-and-other-alternatives.pdf
From a supranational perspective, the Financial Stability Board noted that forward rates derived from overnight risk-free rates would not be as robust as the overnight risk-free rates themselves and the FSB s is focused on using forward rates only for specific use cases. https://www.fsb.org/wp-content/uploads/P120718.pdf
Given the extremely limited use of Euro LIBOR, “old LIBOR currencies” should be understood to refer to the US dollar, British pound, Swiss franc and Japanese yen. Euro lending continues to be primarily based on EURIBOR.
October 27, 2021 LMA publishes exposure draft and commentary on SOFR term for use in developing markets https://www.lma.eu.com/application/files/7716/4362/7703/Member_alert.pdf. We note that the US Loan Syndications & Trading Association published a Term SOFR concept document in August 2021 (https://www.lsta.org/news-resources/lsta-publishes-term-sofr-concept-document/) (updated subsequently updated as of December 2021), but the format of this document was not readily transferable to LMA-type loan agreements used in European syndicated loan markets
Not least because these products are more likely to benefit from forward-looking forward rates and their use in debt service covenants.