In a newly published User's Guide, the Alternative Reference Rates Committee ("ARRC") explained how market participants can use the Secured Overnight Financing Rate ("SOFR") in cash products.

The ARRC called on market participants who are able to use SOFR to not wait for forward-looking SOFR term rates to begin their transition away from LIBOR. Seeking to encourage adoption of the overnight rate in cash products, the ARRC explained the differences between "simple" versus "compounded" average, "in advance" versus "in arrears" compounding, as well as some of the conventions that will need to be adopted to implement overnight rates as replacements for term LIBOR rates.

The ARRC noted that in the short term, using simple interest conventions may be easier; however, compounded interest would "more accurately reflect the time value of money . . . and it can allow for more accurate hedging and better market functioning." The ARRC said that there are specific circumstances where forward-looking term rates can be used most productively, in particular "as a fallback for legacy cash products referencing LIBOR and in loans where the borrowers otherwise have difficulty in adapting to the new environment."

According to the ARRC, in the new ecosystem, the use of a term rate will require more hedging transactions and, therefore, "if end users know that they want to hedge their floating rate payments then it would involve fewer transaction costs if they can modify their systems to be able to pay or receive the compound average SOFR rather than paying or receiving the forward-looking term rate."

Commentary / Lary Stromfeld

With the publication of this User's Guide and (later this week) the final fallback language for new issuances of LIBOR-based floating rate notes and syndicated loans, the ARRC has paved the way for the transition of cash products away from LIBOR. Market participants cannot wait for the development of forward-looking term SOFR. The challenging process of updating systems and implementing more robust language in new issuances and legacy contracts must begin.

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