Is Your Interest Rate going SOFR?

On July 29, the Alternative Reference Rates Committee (“ARRC”) announced its recommendation of CME Group’s forward-looking Secured Overnight Financing Rate (“SOFR”) term rates as a replacement for the London Interbank Offered Rate (“LIBOR”). What, you may ask, does all this alphabet soup mean for you and your business? Essentially, it means that there is a new benchmark floating rate of interest upon which banks and financial institutions will be making commercial loans, arranging for interest rate swaps, and providing other financial products.

LIBOR is a series of interest rates intended to reflect banks’ average cost of short-term, wholesale unsecured borrowing and, for many years, has been a benchmark for lending under the regulation of the United Kingdom’s Financial Conduct Authority (“FCA”). However, changes in the way that banks fund themselves caused the volume of transactions underlying LIBOR to decline considerably. Many of the panel banks relied upon by FCA to determine LIBOR became uncomfortable submitting estimates of their borrowing costs due to the scarcity of unsecured wholesale term borrowing in the market, thus calling into question LIBOR’s sustainability.

In 2014, global regulators noted the financial stability risks associated with continued reliance on LIBOR and national working groups – like ARRC in the U.S. – were convened to support a transition away from LIBOR. In the meantime, FCA convinced its panel banks to continue to provide estimates through the end of 2021. In April 2020, FCA reaffirmed this targeted end date and that all firms should be prepared for LIBOR to be unusable thereafter.

In June 2017, ARRC selected SOFR as its preferred alternative for LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight in the overnight Treasury repurchase agreement (repo) market. Produced daily by the Federal Reserve Bank of New York, SOFR is robust, is based on a deep active market with a diverse set of borrowers and lenders, is not at risk of being discontinued due to a scarcity of underlying transactions and meets international best practices.

SOFR itself is a backward-looking overnight rate because it is based on the previous business day’s overnight transactions, and thus does not allow borrowers and lenders to determine interest until the end of the interest period. However, the CME Group’s Term SOFR is a forward-looking rate as it is based on the large and growing SOFR derivatives market, including SOFR futures and SOFR overnight index swap transactions. Thus, Term SOFR reflects the SOFR derivative market’s expectations as what interest rates will be. With such a large market upon which to base Term SOFR, market expectations are generally closer to actual movements in interest rates, and that reliability was needed for ARRC to recommend Term SOFR as the benchmark replacement for LIBOR.

In anticipation of the end of LIBOR, many financial institutions had already begun adding benchmark replacement provisions in their loan and credit agreements. Such provisions generically provided that, if LIBOR was no longer available or failed to reliably reflect the lender’s cost of funds, an alternative rate of interest would be substituted for LIBOR and provided mechanisms to determine what the replacement rate of interest would be. With ARRC’s recommendation of Term SOFR, those benchmark replacement provisions will most likely default to Term SOFR as the new basis of determining the rate of interest applicable from time to time to the outstanding loans.

If you have a current loan or credit agreement providing for an interest rate determined by LIBOR, look forward to hearing from your banker about transitioning your financing arrangements to interest rates based on Term SOFR. The attorneys at Poole Shaffery & Koegle, LLP would be pleased to assist you in making your transition to Term SOFR.