Industry Update: Term SOFR Announcement and Next Steps
On July 29th, the Alternative Reference Rates Committee (ARRC) announced that it is now formally recommending the CME Group’s forward-looking Secured Overnight Financing Rate term rates (TERM SOFR). The ARRC’s formal recommendation of TERM SOFR is a major milestone in the transition away from USD LIBOR. These rates are officially published on the CME website. Similar to LIBOR, the following TERM SOFR tenors will be available: 1, 3, and 6 months. Union Bank expects to have TERM SOFR products available shortly and more information will follow when that occurs. Click here for more information. For questions or inquiries related to the LIBOR transition please either reach out to your Relationship Manager or utilize the “Contact Me” button above.
What you need to know
This is a brief update of impending changes to the London Interbank Offered Rate (LIBOR). LIBOR has been a long-standing index for financial transactions and is currently the most commonly used variable interest rate index for short-term interest rates, business loans, variable-rate loans, financial derivative contracts, and other commercial lending products.
Things to keep in mind
LIBOR transition timeline
Frequently asked questions
What is LIBOR and why is it important?
The London Interbank Offered Rate (LIBOR) is the most commonly used benchmark for short-term interest rates and often is referenced globally in documentation for derivatives, bonds, business loans and consumer financial products. The setting of LIBOR is made daily on London business days by submissions of the average rates at which LIBOR panel banks believe they can obtain wholesale unsecured funding in 5 currencies (USD, GBP, EUR, JPY and CHF) and 7 maturities (from overnight to 12 months). It is estimated that $200 trillion of financial instruments (loans, bonds, derivatives and consumer financial products) are tied to USD LIBOR.
What is happening with LIBOR?
In March 2021, LIBOR’s administrator and regulator have confirmed the date for the cessation of USD LIBOR. The ICE Benchmark Administration (IBA) will cease publication on a representative basis of the one-week and two-month USD LIBOR tenors immediately after December 31, 2021, and the remaining USD LIBOR tenors immediately after June 30, 2023. The period between end-2021 and mid-2023 is intended to allow legacy contracts to mature. U.S. federal banking regulators have encouraged banks to cease entering into new contracts that use USD LIBOR as soon as practicable and in any event by December 31, 2021. The ARRC also recommends no new USD LIBOR-based contracts to be originated after mid-2021. Transition to alternative benchmark interest rates is well underway, but much work lies ahead in order to implement a successful reference rate change by the end of 2021.
What is the role of the ARRC?
In 2014, the U.S. Federal Reserve and the New York Federal Reserve Bank (NY Fed) established the Alternative Reference Rates Committee (ARRC) to lead industry efforts to transition away from LIBOR. The ARRC continues to play its role. In June 2017, it recommended the Secured Overnight Financing Rate (SOFR) as the replacement for USD LIBOR and encouraged the development of a SOFR futures market.
What is SOFR?
SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities (each a repurchase or repo transaction). While LIBOR is not fully transaction based, SOFR is based on an overnight repo market with ~ $1 trillion of transactions per day. The NY Fed is the administrator and publisher of SOFR. SOFR is published on a daily basis by the Federal Reserve Bank of New York here. Publication of SOFR began in April 2018. Trading and clearing of SOFR based futures began in May 2018 and SOFR-based swaps in July 2018.
How is SOFR calculated?
SOFR is calculated as a volume-weighted median of transaction level tri-party repo transaction data, General Collateral Finance repo transaction data and data on bilateral U.S. Treasury repos cleared through Fixed Income Clearing Corporation's delivery-versus-payment service provided by DTCC Solutions LLC. SOFR is published each business day on the NY Fed’s website.
Does the ARRC have a timeline for the adoption of SOFR?
In April 2021, the ARRC published its progress report on the transition from USD LIBOR, outlining key reference rate reform efforts, progress to date, and areas requiring further work. The “Progress Report: The Transition from U.S. Dollar Libor” also included the ARRC’s 2021 Objectives and Priorities to support a smooth and efficient transition from LIBOR.
The ARRC released in May 2020 its recommended Best Practices for Completing Transition From LIBOR, which subsequently were updated in September 2020. The ARRC’s Best Practices were intended to clarify the timelines and interim milestones for floating rate notes, business loans, consumer loans, securitizations and derivatives that the ARRC believed were appropriate for transitioning away from LIBOR in order to minimize market disruption and support a smooth transition to SOFR.
For existing contracts referencing LIBOR and transitioning to SOFR, do any adjustments need to be made to SOFR to make the economics of the transaction comparable to those based on LIBOR?
As noted by the ARRC, LIBOR and SOFR have different characteristics, and where SOFR is used as a replacement for LIBOR, a spread adjustment will be added to SOFR to make the rate more comparable. Therefore, the ARRC-endorsed fallback language provides for a static spread adjustment that was fixed on March 5, 2021.
For consumer products, the ARRC additionally recommended a one-year transition period to the five-year median spread adjustment methodology.
The ARRC’s recommended spread adjustment values for cash and lending products align with the spread adjustment values that the International Swaps and Derivatives Association (ISDA) plans to implement in its standard definitions for derivatives.
This spread adjustment methodology for cash and lending products is called the Benchmark Spread Adjustment (BSA) and was fixed on March 5, 2021. See Table.
However, even with a credit spread adjustment, no replacement benchmark is likely to be neutral to all parties; some will benefit, and others will not. Additional information from the ARRC regarding spread adjustments can be found here.
What happens to existing transactions and contracts?
A transaction that references LIBOR or another interbank offered rate (IBOR) and matures or expires after the time LIBOR is expected to be unavailable likely will need to be amended or modified.
What is happening to new transactions entered into now and in the near future?
Many continue to reference LIBOR. The ARRC, as well as trade associations and industry working groups, have developed contractual language to be included in contracts known as “fallback provisions” that specify what will happen when the benchmark rate it now references (such as LIBOR) is no longer available. Such provisions reflect industry standard terms and will also be incorporated into new contracts, unless parties explicitly agree otherwise.
What is a fallback provision?
It is a provision in the agreement for a loan, bond, derivative or another financial instrument specifying a new interest rate benchmark or negotiation process to be followed by the transaction’s parties to determine a replacement rate if the interest rate used in that contract becomes unavailable or non-representative. The ARRC has recommended fallback provisions for new USD LIBOR-dependent syndicated and bilateral loans, floating rate notes, securitizations, and residential adjustable rate mortgages that would apply at the time LIBOR becomes unavailable to the extent such provisions are included in transaction documents. Those recommended provisions can be found here.
Given that SOFR is an overnight rate, will forward looking term SOFR be available?
SOFR is solely based on overnight transactions and does not yet have a forward term rate structure. Without a forward term SOFR structure, the alternative SOFR interest calculation methods now prevalent in the market are a compounded or simple average of historical overnight SOFR set in arrears. One limitation in using these calculation methods is that the parties to a transaction will not know the interest rate to be applied during an interest accrual period before the period begins. Not knowing the amount of the next interest payment may create operational issues for some corporate treasurers and others. The NY Fed is publishing indicative forward looking term SOFR on its website. However, these indicative rates are not intended to be used in financial instruments. Learn more here.
The ARRC announced in March 2021 that it (1) will not be in a position to recommend a forward-looking SOFR term rate by mid-2021, and encouraged market participants to continue to transition from LIBOR using currently available tools and (2) cannot guarantee that it will be in a position to recommend an administrator that can produce a robust forward-looking term rate by the end of 2021. In April 2021, the ARRC provided guidance on key principles for an ARRC recommended forward-looking SOFR term rate in order to help guide industry participants as to the conditions that the ARRC believes are necessary to recommend a SOFR term rate.
Additionally, the ARRC identified in May 2021 market indicators that the ARRC will consider in recommending a forward-looking SOFR term rate. The ARRC’s indicators are designed to measure progress in establishing deep and liquid SOFR derivatives and cash markets (which are essential for a robust and stable term rate) and “provide clear guidance that would allow the ARRC to recommend a SOFR-based term rate relatively soon”. The ARRC also reiterated that (a) it has not yet recommended any forward-looking SOFR term rate or administrator, and will continue to consider proposals submitted to the ARRC in order to do so and (b) given U.S. supervisory guidance, the ARRC continues to encourage market participants not to wait for a term rate to transition from LIBOR and to make use of currently available SOFR conventions.
Where can I get updates regarding the ARRC and the IBOR transition process?
What is the current status of initiatives of the International Swaps and Derivatives Association (ISDA) for fallback language supporting LIBOR transition for derivatives (non-cash products)?
ISDA has published a supplement to its 2006 Definitions for derivatives contracts that went into effect on January 25, 2021. New transactions that incorporate the ISDA definitions and reference USD LIBOR or other IBORS will incorporate fallbacks upon specified cessation events for such IBORs to one or more “risk free” reference rates (each a fallback rate) together with a published spread adjustment.
ISDA also published the 2020 IBOR Fallbacks Protocol (the Protocol) in October 2020 to enable market participants to amend derivatives and other contracts to include these new fallbacks. The Protocol, which remains open to the public for adherence, generally covers relevant IBOR transactions governed by ISDA documentation, certain local law swaps and derivatives master agreements, repurchase agreements and securities lending agreements. In addition, ISDA published a series of FAQs for the ISDA 2020 IBOR Fallbacks Protocol FAQ. Learn more here.
ISDA has also published contract templates that parties may employ to bilaterally incorporate Protocol terms or otherwise amend, include or exclude certain master agreements or transactions from the scope of coverage of the Protocol.
Throughout 2021, ISDA published, and plans to publish additional, materials for use by market participants to facilitate LIBOR transition, such as new confirmation templates, updated and additional standard definitions for use in transactions, disclosures and a floating rate matrix covering various benchmarks. On its website, ISDA maintains a page that provides regular updates on ISDA activities and publications: Benchmark Reform and Transition from LIBOR.
Is MUFG / Union Bank actively working on the transition away from LIBOR?
MUFG Union Bank established an enterprise wide IBOR Transition Office in  to manage the transition for our customers and provide oversight for the company. In an effort to mitigate the risks associated with a transition away from LIBOR, MUFG Union Bank has undertaken initiatives to: (i) develop more robust fallback language and disclosures related to the LIBOR transition, (ii) develop a plan to seek to amend certain legacy contracts to reference such fallback language or alternative benchmark rates, (iii) launch and enhance systems to support new products linked to alternative benchmark rates, (iv) develop and evaluate internal guidance, policies and procedures focused on the transition away from LIBOR to other benchmark rates and (v) prepare and disseminate internal and external communications regarding the LIBOR transition.
What should my company or business do right now?
(1) Learn more about LIBOR cessation, transition and replacement rate developments; (2) analyze your LIBOR exposure with a focus on financial instruments maturing beyond 2021 and what effect the discontinuation of LIBOR might have on that exposure; (3) engage with your counterparties, vendors and financial institutions to begin the process of identifying and amending LIBOR-dependent contracts; and (4) consider the impact that a change to a replacement rate may have on accounting, tax, IT, systems and operations.
Follow these links for news and other resources from some of the key industry participants in LIBOR transition:
Recent Industry Updates
Proposed Path Outlines a Clear End Date for USD LIBOR; Would End New Issuances by End-2021, and Subject to Consultation Outcomes, Legacy Contracts Could Mature by Mid-2023
The Alternative Reference Rates Committee (ARRC) today applauded concurrent announcements by LIBOR’s administrator, its regulator, and U.S. regulators, regarding the proposed path forward for the transition away from U.S. Dollar (USD) LIBOR. The announcements include supervisory guidance encouraging banks to stop new USD LIBOR issuances by the end of 2021. They also cite plans to consult on specific timing for ceasing the publication of USD LIBOR, with proposed end dates immediately following the December 31, 2021 publication for the one week and two month USD LIBOR settings, and the June 30, 2023 publication for other USD LIBOR tenors.
TO SOFR OR NOT TO SOFR?
The OCC, Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation issued an Interagency Statement on Reference Rates for Loans reiterating that they are not endorsing a specific replacement rate for LIBOR. Banks may use any reference rate for loans they determine to be appropriate for their funding models and customer needs. The agencies said banks should include language in lending contracts that provides for using a robust fallback rate if the initial reference rate is discontinued.
Capital & Liquidity Memo Published
The ARRC published a memo summarizing its preliminary findings and recommendations about potential regulatory considerations associated with applying current and anticipated capital and liquidity requirements to the LIBOR transition.
ISDA announced the launch of the IBOR Fallbacks Supplement and IBOR Fallbacks Protocol, providing a framework for transitioning USD LIBOR interest rate derivatives to SOFR. 257 derivatives market participants signed on to the Protocol during a two-week "escrow" period.
Following four Credit Sensitivity work shops,official-sector leaders released a letter stating they do not plan to recommend a credit sensitive supplement to SOFR or credit-sensitive rates. They plan to hold two additional working sessions to further discuss the subject and explore related commercial loan transition solutions.
Freddie Mac issued its first SOFR-linked credit risk transfer deal (STACR REMIC 2020-DNA5) that uses 30-day average SOFR, but Freddie Mac intends to transition the transaction to an IOSCO compliant one-month term SOFR if and when it becomes available.
View archived articles here
Disclaimer: The areas and issues covered by this website are continually evolving and you should consult relevant sources and your advisors. Links to some of the relevant working and trade groups are incorporated in the information included on this website. MUFG makes no representation as to the accuracy, completeness or timeliness of such information, which may also be subject to change. The information provided herein is provided for informational purposes only, is not intended to be exhaustive and does not constitute, and should not be relied upon as, legal, regulatory, financial, tax, accounting or other advice. MUFG is not providing any such advice and does not act as your fiduciary. You should consult with your own advisors on the impact of the potential cessation of LIBOR on your business and affairs. MUFG does not warrant or accept responsibility for, and shall not have any liability with respect to, (a) whether the composition or characteristics of any alternative, successor or replacement rate to LIBOR (including SOFR) will be similar to, or produce the same value or economic equivalence of, or have the same volume or liquidity as, LIBOR or (b) the costs, expenses or the consequences related to the cessation of LIBOR or the transition to an alternative, successor or replacement rate thereto. None of the information contained herein represents a commitment or a firm offer to transact, nor does it obligate MUFG to enter into any such commitment.