A Split in the Track: Transition from LIBOR – SOFR as Accepted New Benchmark Rate vs. Other Alternative Benchmark Rates
As discussed in our October 26, 2021 client alert, the ICE Benchmark Administration will cease to publish the USD LIBOR benchmarks on June 30, 2023,1 and the Alternative Reference Rates Committee (the “ARRC”) announced its recommendation that the forward-looking Secured Overnight Financing Rate (“SOFR”) term rates published by the CME Group should be utilized as the new benchmark interest rate for the loan market. Additionally, since March 2020, the Loan Syndication and Trading Association (the “LSTA”) has published form documentation for both the primary syndication market and the secondary transfer market that reference SOFR either as the alternative benchmark interest rate to be used upon the cessation of the availability of USD LIBOR tenors or as the sole interest rate referenced for the underlying transaction.
On October 20, 2021, through a joint statement, several federal and state regulators of financial institutions² urged market participants not to enter into new contracts that use LIBOR as a reference rate after December 31, 2021, as such contracts “would create safety and soundness risks, including litigation, operational, and consumer protection risks” to the regulated entities.
Issues with SOFR
Although many in the market have accepted SOFR as the replacement benchmark rate to be used in place of LIBOR, others believe that due to several of its characteristics, SOFR does not lend itself to be the sole replacement for LIBOR.
First, SOFR is primarily a backwards looking rate rather than a forward looking rate, as its calculations are based upon overnight transactions in the U.S. Treasury repurchase market. As such, it is not possible to know tomorrow’s SOFR rate; on any given business day it is only possible to know the rate of the previous business day. Borrowers in particular have expressed a preference for a forward-looking benchmark to replace LIBOR so that borrowers would be able to predict future cost of the upcoming interest payments. In response to this comment, the CME Group has developed the Term SOFR, a daily set of forward-looking interest rate estimates for the 1-month, 3-month, 6-month and 12-month tenors. However, the Term SOFR simply uses past data to determine future rates, so some are not convinced that Term SOFR provides an adequate solution.
Second, lenders had viewed LIBOR as a useful estimate of the cost of short-term unsecured funding to maintain a positive spread between lenders’ funding costs versus the long term interest earned on outstanding loans. However, as SOFR is based upon secured repurchase transactions, in moments of market crisis, such as the one experienced at the beginning of the COVID-19 pandemic, the use of SOFR as a benchmark rate for loans created a significant mismatch between lenders’ outstanding loans to its borrowers compared with lenders’ current cost of funding. Investors’ flight to safety caused the SOFR interest rates to drop, while at the same time lenders’ funding costs increased due to concerns of the credit health of the banking system.
Investors’ flight to safety caused the SOFR interest rates to drop, while at the same time lenders’ funding costs increased due to concerns of the credit health of the banking system.
Alternative Benchmark Replacement Rates
In light of these disadvantages posed by the use of SOFR as the sole replacement benchmark interest rate to LIBOR, are there any alternatives? Each of the American Financial Exchange (“AFX”), Bloomberg Finance L.P. (“Bloomberg”) and ICE Benchmark Administration Limited (“ICE”) have developed and publish an alternative benchmark interest rate which attempts to solve one or more of the issues raised by the use of SOFR as the sole benchmark replacement to LIBOR.
AFX created the American Interbank Offered Rate (“AMERIBOR”) to reflect actual borrowing costs of thousands of small and medium-sized regional banks which did not use LIBOR and which do not currently use SOFR to fund their balance sheets. AMERIBOR is also a useful rate for loans to small and middle market companies. AMERIBOR is a market-driven benchmark interest rate calculated based on executed transactions with time-stamped transaction identifying numbers as a weighted average of daily transactions in the overnight unsecured loan market on the AFX. The rate is calculated at the close of trading using a following business day convention basis and expressed on an actual/360-day count.
AFX believes that AMERIBOR offers several distinct advantages as compared to SOFR: AMERIBOR (i) contains a credit spread component that is based on unsecured loans rather than collateralized loans, (ii) facilitates loan origination at spreads which represent actual funding costs, and (iii) optimizes asset/liability management by matching asset pricing with liability costs to a single benchmark.
Bloomberg publishes the Bloomberg Short-Term Bank Yield Index (“BSBY”), which represents a series of credit-sensitive reference rates to provide a forward-looking rate that incorporates systematic bank credit spreads. BSBY measures the costs of large banks to access senior unsecured wholesale funding with anonymized transactions including information posted by Bloomberg, money-market electronic trades and reported trades of senior unsecured corporate bonds to calculate overnight, 1-month, 3-month, 6-month and 12-month rates which are published each morning.
One benefit of BSBY is that, while it provides a forward-looking rate and as it is based on actual but anonymous transactions, it does not rely upon subjective data. Bloomberg generates each separate rate by calculating a curve for each separate tenor where the outlier inputs are minimized by the algorithm used to calculate the various rates.
The ICE Index
In January 2019, ICE introduced the ICE Bank Yield Index (the “ICE Index”) to the market and has since published several updates to the ICE Index to inform market participants of the evolution of the methodology to the calculation of the ICE Index.
The ICE Index is designed to measure average yields at which investors would invest for 1-month, 3-month, 6-month and 12-month periods on a senior unsecured basis. The ICE Index implicitly incorporates (i) an underlying U.S. Dollar risk-free rate of return; (ii) a term structure of the average premium over the overnight night risk-free rate for forward-looking time horizons; and (iii) an average premium that investors expect to earn to accept a senior unsecured position over the relevant forward-looking time horizons (1-month, 3-month, 6-month and 12-month periods). The ICE Index is calculated by collecting data for a rolling 5-day period and based on transactions for that day and at least 4 preceding dates. A filter will identify any data points outside the outlier threshold (currently 200 basis points). If any transactions have been identified as outliers, then they are removed from the set of transactions, and the curve is recalculated.
While major banks and lenders of large loans have begun to utilize SOFR as the replacement for LIBOR, lenders have utilized some of these alternative rates recently to address certain issues or particular markets. Borrowers and lenders both should be aware of the options and the benefits and disadvantages of SOFR and benefits and disadvantages of some of the alternative benchmark rates. Often, a one-size-fits-all approach might not work for all institutions or for all loan transactions. However, lenders and borrowers should note that these benchmark rate alternatives have a lower liquidity than SOFR, and a critical mass of market participants has not rallied around any single alternative to SOFR. Since the end of 2020, the LSTA has implored lenders to include in all current credit agreements and amendments provisions to outline the transition to an alternative interest rate. Borrowers should review these provisions to confirm if the borrower agrees with the proposed interest rate to be used upon the shift from LIBOR. Likewise, at the term sheet stage, lenders should consider which alternative interest rate benchmark should be utilized as the replacement rate for the underlying transaction.
1 The most widely used tenors of the USD LIBOR benchmarks will cease to be published on June 30, 2023, but the less utilized USD LIBOR rates will cease on December 31, 2021.
2 The Board of Governors of the Federal Reserve System, the Consumer Financial Protection Bureau, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency and unspecified state bank and credit union regulators published this joint statement.