Now nearing six months from the date that several US agencies recommended for the cessation of new U.S. Dollar LIBOR contracts (December 31, 2021), a clear winner has emerged as the replacement rate for floating rate commercial loans: CME Term SOFR. While certain tenors of LIBOR will be published through June 30, 2023, to allow time for loans without a fallback rate to be renegotiated, LIBOR is all but dead for new loans. New borrowers, or borrowers with LIBOR loans without a fallback, should familiarize themselves with a few interesting points regarding CME Term SOFR.
Why Did LIBOR End, Again?
LIBOR served for 40 years as the widely accepted short-term benchmark interest rate for loans world-wide. But the rate was never intended for this use, but rather a reference rate for banks borrowing funds from other banks, and its calculation method is inherently flawed.
LIBOR is the average of the stated rates from 18 international contributor banks. Each bank reports the rate that they expect to pay if the bank were to borrow on the interbank lending market in London. LIBOR is not based on actual past transactions or even published rates, but rather on the stated rate submissions of these contributor banks. This rate methodology proved problematic in several instances, and two of note.
First, LIBOR was a contributor to the severity of the 2008 financial crisis. As the financial crisis worsened and individual banks ability and desire to lend to one another diminished, each reported higher and higher rates. LIBOR then rose out of sync with the market as a whole, further cooling the market. This was despite drastic moves by global banks and governments to slash actual interest rates to borrowers, and worked against the governments’ ability to tame the crisis.
Second, because the rates contributor banks submit are merely the stated rates, unscrupulous bankers could submit false rates in order to manipulate LIBOR up or down to their own advantage in the market. This is exactly what happened in the 2012 rate manipulation scandal, which led to waves of fines and regulatory changes against many of the world’s largest banks, including Deutsche Bank (DB), Barclays (BCS), Citigroup (C), JPMorgan Chase (JPM), and the Royal Bank of Scotland (RBS). This led to a reluctance of contributor banks to contribute stated rates given the risk of future liability based on claims of manipulation, further weakening the accuracy and reliability of LIBOR.
While there appeared a consensus among market participants that LIBOR had to go, what to replace it with was a harder question. A government-controlled rate would not provide the flexibility and accuracy that private market participants demanded, while a rate that was generated on a purely private basis, or by one market participant, was ripe for manipulation. A rate based on one of the rates published by one of the US Federal Reserve banks emerged as the proposed solution.
Why was CME Term SOFR Chosen as replacement rate of choice?
In the years leading up to the end of LIBOR several rates emerged as proposed replacements, with three as the prominent choices.
The first, the Standard Overnight Funds Rate (“SOFR”) published by the New York Federal Reserve as its nearly ‘risk-free’ overnight, secured rate to borrow cash, appeared to solve many of the problems with LIBOR, but came with its own issues. Because the rate is a nearly “risk-free” overnight rate calculated based on borrowings for the night prior, it did not capture market risk nor was the rate forward-looking. SOFR is calculated based on the prior night’s deposits, but with LIBOR, banks reported rates considering market risk factors on an anticipatory basis. In addition, since SOFR is a nearly ‘risk-free’ rate, the use of SOFR as a LIBOR replacement necessarily required a spread adjustment, as no private loan can ever be considered risk-free.
The second was proposed by the maker of Bloomberg financial terminals, nearly universally used by financial firms of all sizes to acquire financial information, the Bloomberg Short Term Bank Yield Index (“BSBY”). BSBY received some initial headway in the market as Bank of America and other major market participants used it. The rate is a forward-looking rate and included an appropriate risk spread, but where it is primarily controlled by one market participant, it was not popular with U.S. regulators. Eventually regulatory pressure slowed the adoption of BSBY, and, perhaps has doomed it to be no more than a potential fallback rate.
Finally, the Alternative Reference Rates Committee (“ARRC”), a group of private market participants convened by the New York Federal Reserve, definitively recommended a form of SOFR developed in response to its criticisms, CME Group Incorporated’s (“CME Group”) Term SOFR. This rate is published by the owner of a leading derivatives marketplace, the CME Group, which is the owner of four exchanges (Chicago Mercantile Exchange [“CME”], Chicago Board Of Trade [“CBOT”], New York Mercantile Exchange [“NMEX”] and the Commodity Exchange [“COMEX”]). It is designed to be forward-looking and calculated in various tenors based upon market risk at the time of issuance, including the CME Group’s expertise and informational access with regard to futures contracts traded on its derivatives exchanges. While the rate does not entirely adjust for SOFR’s nearly risk-free nature, ARRC’s recommendation included a spread-adjustment calculated by the ARRC and its participants and designed to be included in any usage of the rate as a reference rate.
What to Know About CME Term SOFR
- CME Term SOFR is presently published in four tenors or terms, 1, 3, 6 and 12 months, similar to LIBOR.
- Borrowers can continue to expect fallback language to other alternate rates in loan documentation. This was recommended by the ARRC to avoid any further market uncertainty in the (unlikely) event CME Group were to fail to publish its term SOFR rates. Alternate rates may include daily simply SOFR, BSBY, or the lender’s prime rate.
- Since LIBOR is generally higher than the CME Term SOFR, ARRC recommended language including a spread adjustment based on the tenor of the loan. In commercial lending, this is generally the 1-month rate with a spread adjustment of 11.448 basis points.
- While the ARRC suggested language which added the spread adjustment to the determination of CME Term SOFR, some lenders are instead including the spread adjustment in the quoted margin; and
- Borrowers comparing rates should be keen to confirm if the spread adjustment is included in the quoted margin over CME Term SOFR, or will be in addition to the published rate for CME Term SOFR plus the stated margin.
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