ARRC issues updated guidance on the scope of Term SOFR

The Alternative Reference Rates Committee (ARRC) issued updated guidance regarding the scope of use for Term Secured Overnight Financing Rate (SOFR) derivatives. This is a positive development for financial institutions that intend to use Term SOFR as an alternative rate as they transition away from LIBOR.

There are various non-LIBOR rate alternatives to consider, and Chatham does not recommend a particular alternative. Each financial institution should evaluate and determine which non-LIBOR alternative is best for their institution.

On July 29, the ARRC officially recommended Term SOFR and released best practices related to its use. At that time, the ARRC stated that, pursuant to the Financial Stability Board mandate to increase robustness in the risk-free rate market, the use of Term SOFR derivatives should be limited to end-users hedging cash products. This limited endorsement raised concerns for community and regional financial institutions that could be at a competitive disadvantage if customers sought Term SOFR financing with a Term SOFR swap to fix the debt service, but the institution could not undertake an equal and offsetting hedge with a dealer.

Chatham immediately collaborated with individuals from the ARRC, the Chicago Mercantile Exchange (CME), the Federal Reserve Board, and various market participants to ensure that attention was given to this lack of clarity in the endorsement and to advocate on behalf of our financial institution clients. We are pleased by this announcement and hopeful that it clears an obstacle for those institutions planning to implement Term SOFR.

The revised scope of use reiterates that end users may wish to hedge cash products that reference Term SOFR with Term SOFR derivatives and that the ARRC supports such use. Relative to this recommendation, an end user is described as any party to the underlying cash product, such as a borrower, lender, or guarantor. These parties may then enter into Term SOFR swaps, caps, swaptions, or other derivatives to hedge cash product exposure or a portfolio of exposures and may also adjust or unwind these exposures, including by way of novation. Importantly, a financial institution that is not a CFTC-registered Swap Dealer or interdealer market maker in interest rate derivatives may also offset such exposure with an upstream dealer.

The ARRC re-emphasized that it does not endorse the use of Term SOFR derivatives for most of the market, including CFTC-registered Swap Dealers, and encourages the use of derivatives based on SOFR overnight and SOFR averages where possible, even for end users. The ARRC is not a supervisory body and it is important that you remain in communication with your regulators to determine the permissible rates for your financial institution.

The ARRC previously selected the CME to be the administrator of Term SOFR, and use of Term SOFR in this manner shall also be in accordance with the CME’s licensing terms. You can find information regarding these terms here which are subject to change.

Today, it is not possible to execute a Term SOFR derivative in the marketplace. The original endorsement and this updated guidance, combined with the SOFR First Initiative, should allow for this market to develop. We cannot address, however, how quickly Term SOFR swaps will be provided by swap dealers at this time.

We will continue to advocate for our clients and assist them in the evaluation process of these alternative rates.