The Development: The Alternative Reference Rates Committee ("ARRC") announced the results of its market consultation on the "spread adjustment" calculation for the LIBOR/SOFR transition on May 6, 2020, but found it necessary to launch a second consultation in an effort to contain potentially excessive complexity entailed by the results.
The Significance: The need for the ARRC's second consultation highlights the potential trade-offs between simplicity and accuracy as the ARRC continues to assess a range of term structure constructs, including a true forward-looking risk-free rate.
Looking Ahead: Responses to the ARRC's second spread adjustment consultation are due June 8, 2020. We additionally expect further unexpected complexities to emerge as future decisions are made and applied to the range of risk-free rates under consideration by the ARRC.
The transition from the London Interbank Offered Rate ("LIBOR") for United States dollars to its presumptive successor, the "risk-free" overnight Secured Overnight Financing Rate ("SOFR"), requires two adjustments to SOFR to be as "fungible" as possible with LIBOR: (i) the construction of an actual or synthetic term structure; and (ii) a credit spread adjustment to be added to the various tenors so constructed. The International Swaps and Derivatives Association, Inc. ("ISDA") determined some time ago that, for derivatives, term construction would be effected by means of compounding SOFR (and all other overnight reference rates globally) daily over the course of a given accrual period ("compounding in arrears") and taking the average as the "risk-free" rate for that accrual period. To this would be added a "spread adjustment" determined on a one-time basis (i.e., the credit spread would be "fixed" and not "dynamic") equal to the median daily spread between SOFR compounded in arrears for each tenor and its LIBOR equivalent over a period of five years preceding the applicable "trigger event," which is roughly when the precise timing of LIBOR cessation will become fixed.
The ARRC is the largely private sector body convened by the Federal Reserve to guide LIBOR transition in the United States. The ARRC launched its own market consultation ("First Consultation") on spread adjustment methodologies in January 2020 for "cash" market products (business loans, floating rate notes, securitizations and mortgages, and other consumer products). Unlike ISDA, however, the ARRC aspires to a "true" forward-looking term SOFR and is also continuing to consider a number of different "synthetic" term construction techniques that include, in addition to compounding in arrears, "compounding in advance" (compounding SOFR daily for the period equivalent to a given accrual period ending immediately prior to the accrual period such that the applicable rate will be known from the accrual period's commencement) and "simple" averaging of SOFR both in arrears and in advance.
The First Consultation requested market participant input on a number of questions, including whether the "ISDA methodology" (five-year median spread) or another methodology (other candidates included averages and "trimmed" medians and averages over a variety of time periods ranging from 3.5 to 10 years). The ARRC reported on May 6, 2020, that responses were nearly unanimous that the "ISDA methodology" should be utilized across all products.
However, the ARRC appears to have belatedly realized that the single "ISDA methodology" for up to five different rate/tenor sets has the potential to yield an overly complex set of spread adjustments, which although expected to be similar may not be identical. The ARRC accordingly seeks market input ("Second Consultation") as to whether simply to adopt the ISDA "value" (the determination of which, as provided by ISDA's "Adjustment Services Vendor," Bloomberg Index Services Limited, will be extraordinarily complex on its own) for all actual and synthetic term rate structures under consideration.
The Second Consultation also requests input as to whether the five-year measurement period for a "pre-cessation" trigger consisting of a regulatory declaration of "non-representativeness" should also be aligned with ISDA's, given ISDA's recent decision to adopt such a trigger. This "pre-cessation" trigger has existed within the ARRC's recommendations since the very start, but has proven more controversial for the derivatives markets.
The ARRC's proposed spread adjustment simplification is to be welcomed, even if perhaps at the expense of intellectual and financial purity. It would ensure alignment with derivatives for cash products that utilize SOFR compounded in arrears and avoid the need for multiple sets of spread adjustments. However, the Second Consultation also graphically demonstrates the complexities that can result from the number of term construction options remaining under consideration by the ARRC. Every decision threatens to be magnified exponentially and/or to be open for reconsideration as it gets propagated across various term construction techniques and actual tenors.
Three Key Takeaways
- At stake in the Second Consultation is essentially whether the ARRC will defer entirely to ISDA's spread adjustment calculation across the range of risk-free term structures still under consideration by the ARRC.
- The ARRC's continuing assessment of these structures is necessitated by the demand from borrowers, and in particular consumers, for certainty in advance as to what their interest payments will be in advance.
- However, the ARRC's experience with the relatively straightforward spread adjustment calculation augurs huge amounts of continuing complexity and uncertainty, as more subtle operational day-count and other conventions work their way through various term rate structures.
Originally published Jones Day, May 2020
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