All Aboard! The Train Is Speeding Along: Transition from LIBOR – What Market Participants Need to Know About CME Term SOFR Licenses
As discussed in our January 29, 2021 client alert, the ICE Benchmark Administration will cease to publish the most widely used tenors of the USD LIBOR benchmarks on June 30, 2023.1 Additionally, financial institutions have been advised not to utilize the most widely used tenors of the USD LIBOR benchmarks for any financial products that begin after December 31, 2021.
On July 29, 2021, the Alternative Reference Rates Committee (the “ARRC”) formally announced its recommendation to use the forward-looking Secured Overnight Financing Rate (“SOFR”) term rates published by the CME Group, the benchmark administrator which calculates SOFR, to replace the USD LIBOR benchmark as the basis interest rate for the market. Upon receipt of the ARRC’s support of SOFR, the CME Group announced that future access and use of the CME Term SOFR Reference Rates (“SOFR Reference Rates”) will require lenders, borrowers, parties which enter or sell derivative contracts and other entities that use SOFR interest rates as part of their business practices (“Market Participants”) to obtain one or more licenses issued by the CME Group. While Market Participants will be able to obtain one of these licenses and rights to access the SOFR Reference Rates from Bloomberg or Refinitiv, most licenses will only be issued and administered by the CME Group directly.
The CME Group intends to maintain the status quo with respect to licensing requirements to resemble those which currently exist with respect to the use of USD LIBOR benchmarks. As such, the rights offered to holders of the licenses issued by the CME Group will be similar to the interests provided to licensees under existing licenses needed to access the USD LIBOR benchmark.
The CME Group will issue a license to a parent institution for the benefit of such institution’s subsidiaries and certain of its affiliates. If more than 50% of the ownership of an affiliate is controlled, either directly or indirectly, by a parent institution, such affiliate will receive and retain the same rights to access or use the SOFR Reference Rate as granted to the parent institution under the license held by the parent institution.²
Types of SOFR Licenses
The CME Group will issue three types of licenses to Market Participants: an Access License, a Use License and a Distribution License. However, the CME Group has also advised that, depending upon how particular institutions intend to utilize the SOFR Reference Rates, in certain circumstances, some institutions might not need to obtain any license.
An Access License grants a licensee the right to receive the SOFR Reference Rate to track performance or perform other activities for the benefit solely of the licensee and its affiliates (as described above). If a Market Participant utilizes the details of a SOFR Reference Rate for internal analysis or circulates the same amongst affiliates, a Display License would be required, but if an institution simply verifies the details of a certain SOFR Reference Rate without performing any additional analysis, no Access License likely would be required. Technically, though, the access to see the SOFR Reference Rates would be covered by an already existing license an institution has with a third-party vendor, such as Bloomberg or Refinitiv. There are two primary means by which an institution can access the SOFR Reference Rate, and each manner requires a different license.
(1) Display License. This license is required to view any SOFR Reference Rate on a terminal, a screen or other display device. A Display License can be obtained from a third-party vendor or from the CME Group.
(2) Non-Display License. Unlike the Display License, a Non-Display License does not provide a party with a right to have a visual display of the relevant SOFR Reference Rates. Instead, a Non-Display License would be required to access a SOFR Reference Rate through a machine, an application, an algorithm or a software product. Use of any such SOFR Reference Rate accessed via a Non-Display License would permit a Market Participant or its affiliates to perform calculations of projections and other analysis. Only the CME Group can provide a Non-Display License.
As of the date of this alert and per discussions with the CME Group, the CME Group had not yet established the cost to acquire either a Display License or a Non-Display License, but the CME Group anticipates that the fee for such Access Licenses would be based upon the fair reasonable and equitable (“FRAND”) costs of the CME Group to administer the benchmark rates and the licenses.
Any Market Participant which will use the SOFR Reference Rate as a data input or as a reference in valuation, pricing, transactional or benchmarking activities would be required to obtain a Use License. Additionally, a Use License would be required if a Market Participant uses the SOFR Reference Rates in a system for analysis of risk or collateral management or by parties that seek to access historical SOFR Reference Rates. A Use License is also needed for cash market financing products and derivatives that hedge cash instruments, as well as for the securitizations of underlying assets that are themselves tied to SOFR Reference Rates. Unlike Access Licenses, only the CME Group is able to grant a Use License.
End users, which are transaction counterparties that confirm a SOFR Reference Rate applicable in transactions, will not need to obtain a Use License. Such end users include borrowers in loan transactions, as well as trade counterparties or guarantors of applicable cash market financial products or of OTC derivatives. However, if in addition to confirming an actual SOFR Reference Rate, such end user were to perform additional activities, such entity would be required to obtain either an Access License or a Use License, depending upon what other activities such Market Participant conducted. The mere act of a borrower borrowing on a SOFR Reference Rate basis pursuant to a SOFR rate quoted by a lender does not in and of itself require the borrower to acquire a SOFR license. But direct access by the borrower to quoted SOFT Reference Rates for purposes of analysis would require a borrower to obtain a license.
The CME Group has divided the Use Licenses into two categories: a Category 1 License for the use of the SOFR Reference Rate with cash market financial products, and a Category 2 License for use of the SOFR Reference Rate with respect to OTC derivative products. Note, however, that in order for a Market Participant to obtain either a Category 1 Use License or a Category 2 Use License, the licensee would need to hold either a Display Access License or a Non-Display Access License.
(1) Category 1 License. A Category 1 License is required if a SOFR Reference Rate is used as a reference rate for cash market financial products. Such use would include any of the following:
- for reference rates in loans, mortgages, notes and money market instruments;
- as a primary reference rate or fallback rate in connection with interest amounts or default rates;
- for valuation and pricing activities including, but not limited to, collateral calculation, interest rate calculations and the calculation of pricing, discount or forward curves;
- for communication with or disclosure to third parties in connection with performance measurements or return calculations; and
- for purposes of the transition or conversion of a LIBOR-based product.
The CME Group has confirmed that a borrower in a loan transaction does not need to obtain a Category 1 Use License. Likewise, an individual borrower of a loan secured by a stock portfolio is not required to have a Category 1 Use License. However, in either case, if the borrower were to utilize the SOFR Reference Rate as in input for collateral calculation or for valuation or pricing activities, such borrower would be required to have a Category 1 Use License. The CME Group requires a lender in a syndicated loan or a lender making a loan directly to a borrower to obtain a Category 1 Use License.
The CME Group will provide the Category 1 Use License without charge through December 2026. Per conversations with the CME Group regarding the future cost of Category 1 Use Licenses, while not yet established, the CME Group intends that the fees charged for Category 1 Use Licenses will reflect the FRAND costs to the CME Group.
(2) Category 2 License. A Category 2 License is required for an OTC derivative product (such as structured products, swaps, security-based swaps, forwards, warrants, options, repos and other similar instruments) if the derivative instrument is linked to a licensee hedging against exposure from a cash market financial product that utilizes the same SOFR Reference Rate as the OTC derivative product. Pursuant to the terms of the CME Group Category 2 License, the SOFR Reference Rate cannot be used for financial products that are listed on an exchange, a trading platform or another trading venue. As SOFR Reference Rates are derived from CME SOFR futures, the CME Group has stated that the use of the SOFR Reference Rate should be limited to avoid detracting from the volume of the underlying SOFR Reference Rate-based derivatives on which the CME Group relies to calculate the actual SOFR Reference Rate.
The CME Group has confirmed that a financial institution might need to obtain both a Category 1 and a Category 2 License. For example, if a Market Participant requires use of the SOFR Reference Rate in a loan product, but also enters into a swap to hedge the exposure underlying that loan product, the institution would need both a Category 1 and a Category 2 License to access and use the SOFR Reference Rate for the two different financial instruments.
The CME Group currently does charge a cost to issue a Category 2 Use License. The fee schedule for a Category 2 Use License is based upon the total assets of the licensee. The CME Group will not charge a fee to Financial Institutions and Non-Financial Institutions (each term as defined in Appendix A to Schedule 7 to the Information License agreement Index & Benchmark License (“Appendix A”)) with total assets less than $1.5 billion, while the cost for a Category 2 License of a Financial Institution with more than $10 billion in total assets would be $8,000 per year. The CME Group will issue a Category 2 License to a Public Policy Financial Institution (also as defined in Appendix A) at no charge.
The CME Group prohibits either a Category 1 Licensee or a Category 2 Licensee from using its access to the SOFR Reference Rate to conduct any of the following activities: (i) to issue or list any OTC derivative products or other financial products listed on an exchange or other trading facility; (ii) to provide counterparty clearing services; or (iii) to conduct activities not specifically permitted by the CME Group’s license agreement, such as the creation of a benchmark or an index.
Finally, as required by the benchmark regulations that govern the CME Group’s distribution of the SOFR Reference Rates, Use Licensees must provide the CME Group with annual reports of aggregate total notional value such licensee uses the SOFR Reference Rates as direct or indirect input values.
In addition to an Access License and a Use License, the CME Group will require a Market Participant to obtain a Distribution License if such Market Participant intends to distribute the details of the SOFR Reference Rates to third parties. As of the date of this alert, the CME had not yet determined the costs to acquire a Distribution License, though the cost will likely be based upon the FRAND costs to the CME Group.
The CME Group encourages all Market Participants to review immediately their trading practices and potential future uses of the SOFR Reference Rates to determine if or what type(s) of license such institution might require. The CME Group has sales representatives and account managers available to help guide institutions through the licensing process, which process would begin when each Market Participant provides the CME Group with historical trading and other data to determine which type of license(s) would be required to conduct the same activities in the future. The CME Group has provided the form Information License Agreement Index and Benchmark License on its website at https://www.cmegroup.com/market-data/files/information-license-agreement-ila-guide.pdf for Market Participants to review in conjunction with the transition from LIBOR to SOFR Reference Rates.
Kleinberg Kaplan’s LIBOR transition team has been actively following the LSTA and other industry developments relating to LIBOR transition. If you have any questions or would like to discuss, please reach out to any of the authors or your regular Kleinberg Kaplan contact.
1 Per the prior client alert, the less utilized USD LIBOR rates will cease on December 31, 2021.
2 As of the date of this alert, the CME Group had not yet confirmed whether an affiliate retains the rights under the same license as the parent institution if less than 50% of the ownership of the affiliate is controlled by the parent institution, but if such affiliate is only contractually controlled, directly or indirectly, by the parent institution.