Time for Term SOFR?

Despite this, its use in the European syndicated loan market remains very limited, where instead the SOFR compounded in arrears methodology is predominantly used for U.S. Dollar loans. There are a few obstacles to the use of Term SOFR in European markets, not least of which has been the lack of clear industry or regulatory guidance in the UK and Europe, but recent trends suggest that the use of Term SOFR will soon become more widespread.

Which rules apply?

The Financial Conduct Authority and Prudential Regulation Authority’s joint “Dear CEO” letter in March 2021 provided that market participants should use the most robust alternative rates taking account of relevant industry guidelines and recommendations.^[1] Following the recommendation by the U.S. Alternative Reference Rates Committee (ARRC) of CME Group’s Term SOFR in July 2021^[2], during the September 2021 meeting of the Working Group on Sterling Risk-Free Reference Rates (£WG) it was noted by members of the £WG that the ARRC’s recommended best practice for Term SOFR would be relevant for U.S. Dollar business in London^[3]. This suggests that despite the current market practice of using overnight rates compounded in arrears, Term SOFR can be adopted in UK markets in situations where it follows the U.S. recommendations. Although the ARRC recommends “as a general principle” that market participants use overnight SOFR and SOFR averages^[4] as these are the most robust reference rates, the ARRC supports the use of Term SOFR “for business loan activity - particularly multi-lender facilities”. This industry guidance has manifested into industry practice as U.S. syndicated loans commonly use Term SOFR as a benchmark rate.

The minutes of the £WG meeting go on to say that “[g]uidance should be followed for each currency respectively including in multi-currency facilities”. This means that, while compounded in arrears is the clear approach for Sterling syndicated loans, the door appears to be open to use alternative approaches for other currencies.

Historical headwinds

Despite this a number of additional factors have caused European lenders to be hesitant to use Term SOFR:

• Contrasting guidance on use of term rates: In contrast to the ARRC’s recommendations for U.S. Dollar lending, the £WG position supported by UK regulators is that Term SONIA, the equivalent forward-looking term rate for Sterling, should only be used in a very narrow set of circumstances where a forward looking rate is necessary such as emerging markets, Islamic financing or where certainty of an interest rate in advance is a key consideration such as retail borrowing^[5]. This firm position against the use of term rates more broadly^[6] and the comparatively little guidance from regulators or working groups on the conventions to be used in respect of currencies outside of that regulator’s jurisdiction have arguably made UK and European lenders more cautious on the use of Term SOFR.
• Documentary inertia: The vast majority of new risk-free rate loans in the European syndicated market follow the drafting and conventions contained within the Loan Market Associations’ (the LMA) recommended form agreements. The LMA uses a compounded in arrears approach for the former LIBOR currencies^[7] and has generally followed the £WG recommendations for Sterling even in a multicurrency context. This uniform approach has become entrenched in European markets and, as discussed below, there are a number of documentary issues in a multicurrency context regarding the implementation of Term SOFR for U.S. Dollars which have yet to be resolved.
• Operational constraints: As a result of the £WG’s recommendations for no new Sterling LIBOR lending after Q1 2021, lenders with Sterling exposures had already built their operations infrastructure on the basis of compounded risk-free rates before there was any certainty Term SOFR would be recommended in the U.S. Even following the recommendation of Term SOFR, European markets continued to use SOFR compounded in arrears and some institutions may lack the operational capacity or clearance to use Term SOFR. Therefore even where some lenders in a syndicate are Term SOFR-ready (typically U.S. banks), other lenders may not be operationally ready to use the rate at this stage.

Implementing Term SOFR

For participants in Europe intending to use Term SOFR the primary documentary aid is the LMA’s exposure draft (the Exposure Draft) on the use of Term SOFR in developing markets.^[8] While this document is helpful in putting Term SOFR into a form familiar to participants in the European syndicated loan markets (in contrast to the documentary forms used in the U.S. markets), the Exposure Draft is not a conclusive statement on how to implement the rate and leaves open a number of unresolved points:

• Fallbacks – The Exposure Draft largely replicates the waterfall of fallbacks applicable under LMA documents for the temporary unavailability of EURIBOR (or LIBOR); i.e. interpolation, shortened interest period and historic rate, etc. However, this waterfall is incomplete as it does not provide for long term fallbacks and the short term fallbacks that are included are for illustrative purposes only rather than a reflection of market practice. Further given the shortest published tenor for Term SOFR is one month, there are issues with interpolation for tenors of less than one month. In the U.S., if Term SOFR were to cease or become non-representative, the loans would typically apply either a hardwired option to Daily Simple SOFR or an amendment approach which allows the borrower and agent to determine the rate and spread adjustment which is based prevailing market rates and recommendations by relevant governmental authorities with a negative consent right from a requisite number of lenders.
• Break costs, market disruption and cost of funds – The LMA notes that each of these concepts is underpinned by the fundamental premise that lenders are assumed to be term-funding their participation in a facility and price on the basis of a 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 not relevant in current markets where banks fund themselves from a variety of sources and matched-funding is not necessarily achievable or desirable. The move away from LIBOR to risk-free rates (whether applied in arrears or as a term rate) further erodes the idea that the interest rate benchmark is a proxy for a lenders actual cost of funds as risk-free rates do not have any connection to lenders’ cost of funds.
• Hedging – Of particular relevance to more structured financings such as project or real estate finance loans^[9] is the ability for borrowers to obtain interest rate hedging. Although the ARRC has generally recommended against the use of Term SOFR in derivative products, it does permit such products where the benefit is to an “end user”, i.e. the borrower which is exposed to Term SOFR cash products[10]. As the guidance only permits hedging agreements with an “end user”, hedge counterparties should not enter into any back to back arrangements that reference Term SOFR and must bear the basis risk of hedging its own exposure using overnight SOFR based products. Liquidity is lower in the Term SOFR derivatives market relative to the overnight market, potentially resulting in higher costs to obtain the hedging. Borrowers may prefer to use compounded SOFR for their loans in order to benefit from the lower costs and greater liquidly in that derivatives market. Parties should also consider the degree of basis risk which may arise due to differences between the temporary and permanent fallbacks contained in the ISDA definitions and the fallbacks set out in the loan agreement.

Conclusion

While some regulated entities may continue to view the use of Term SOFR with caution without a definitive statement from UK or European regulators, the current UK guidance would appear to suggest that participants can adopt this rate for U.S. Dollar lending in line with ARRC’s best practice recommendations. Documentary and operational challenges remain, but these are not insurmountable.

_{^[1]https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/letter/2021/march/transition-from-libor-to-risk-free-rates.pdf?la=en&hash=28D5CAB6CE11D930906FAEE35C86982FE159375E}

_{^[2]https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/ARRC_Press_Release_Term_SOFR.pdf}

_{^[3]https://www.bankofengland.co.uk/minutes/2021/september/rfr-september-2021}

_{^[4]https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/ARRC_Scope_of_Use.pdf}

_{^[5]“Use Cases of Benchmark Rates: Compounded in Arrears, Term Rate and Further Alternatives” https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/use-cases-of-benchmark-rates-compounded-in-arrears-term-rate-and-further-alternatives.pdf}

_{^[6]From a supra-national perspective, the Financial Stability Board has noted term rates derived from overnight risk-free rates would not be as robust as the overnight risk-free rates themselves and the FSB focused on using term rates only in specific use cases. https://www.fsb.org/wp-content/uploads/P120718.pdf}

_{^[7]Given the extremely limited use of Euro LIBOR, “former LIBOR currencies” should be taken to refer to US Dollars, Pounds Sterling, Swiss Franc and Japanese Yen. Lending in Euro continues to primarily be based on EURIBOR.}

_{^[8]27 October 2021 LMA publishes term SOFR exposure draft and commentary 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/) (subsequently updated in December 2021),  however the format of this document was not readily transferable to the LMA-style loan agreements used in the European syndicated loan markets}

_{^[9]In particular because these products are more likely to benefit from forward-looking term rates and their use in debt service covenants.}

_{^[10]https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/ARRC_Scope_of_Use.pdf}