On January 21, 2020, the Alternative Reference Rates Committee ("ARRC") released a consultation on methodologies for spread adjustments (the "Consultation") to be used in USD LIBOR contracts, such as floating rate notes, that use the ARRC's hard-wired recommended fallback language.1 That fallback language provides a mechanism for a USD LIBOR floating rate note to shift over to the secured overnight financing rate ("SOFR") at the time that LIBOR ceases publication.2 The ARRC's recommended fallback language, however, is currently missing two elements.
The first fallback from USD LIBOR, term SOFR, does not yet exist and is not expected to become available prior to the cessation of LIBOR. The second missing piece is the spread adjustment to be added to SOFR. The goal of the Consultation is to achieve a consensus in the market on the methodology for calculating the spread adjustment, which would be static and would be fixed at a specified time at or prior to LIBOR's cessation and make the spread-adjusted SOFR rate comparable to LIBOR by minimizing the expected change in value resulting from the change in rates.
SOFR is a backward-looking secured overnight rate, while LIBOR is a forward-looking unsecured rate published with different tenors, and also incorporates an element of bank credit risk. Consequently, the two rates differ, with LIBOR tending to be higher than SOFR, and the two rates having different responses to stressed markets. The spread adjustment is designed to minimize any change in the value of the contract (such as a floating rate note) when moving from LIBOR to SOFR. Once a methodology is adopted by the ARRC, it would be the same across different LIBOR tenors, but would be applied separately to each tenor.3 There would be a different spread adjustment for each LIBOR tenor, although the methodology would be the same.
The Consultation looks to the spread methodologies proposed by the International Swaps and Derivatives Association, Inc. ("ISDA") and builds upon them. It is important to align the spread methodologies with those put forward by ISDA in order to minimize any basis risk in hedges related to LIBOR floating rate notes and other LIBOR contracts. A majority of respondents to a recent ISDA consultation on parameters for the derivatives market supported a static spread adjustment for derivatives, which adjustment will be calculated as the median of the historical difference between a given tenor of USD LIBOR and a compound average of SOFR in arrears of a corresponding tenor. The median difference will be calculated using the five years of historical data preceding a trigger event causing a switch from USD LIBOR to SOFR. The ISDA spread adjustments will be static, as they will be set at one point in time (when a trigger event occurs, causing the USD LIBOR floating rate note to switch to SOFR) and will not be revised once determined.
The Consultation addresses a number of choices that need to be considered in selecting a replacement spread adjustment methodology:
- Whether the same methodology and parameter choices should be used to calculate the spread adjustment for compounded average SOFR in arrears, compounded average SOFR in advance, and a forward-looking term rate;
- How the long-run level of the difference between LIBOR and SOFR should be measured;
- How far back in time data should be reviewed to estimate the long-run level; and
- How quickly the spread adjustment should move to the long-run historical level.
The Consultation includes extensive comparison data to help market participants make informed choices about the spread adjustment methodology, and ends with a list of questions to be answered by market participants. The comment period ends on March 6, 2020.
Originally published in REVERSEinquiries: Volume 3, Issue
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1. The Consultation is available at: https://nyfed.org/2OeNooy.
2. We discuss in detail the ARRC's recommended fallback language in our Legal Update dated May 2, 2019, available at: http://bit.ly/2rYcccs.
3. The spread adjustment would be calculated for 1, 2, 3 and 6-month USD LIBOR and 1-year LIBOR. One week and overnight LIBOR tenors will not have spread adjustments as those tenors are rarely used.
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