The journey towards a robust and stable forward-looking SOFR term benchmark replacement rate (Term SOFR) appears to be nearing its end. The Alternative Reference Rate Committee (ARRC) announced in its press release on June 8, 2021 that the final market indicator for Term SOFR becoming robust and stable enough to be formally recommended is expected to be satisfied following the adoption of a recommended change to USD linear swap trading conventions from USD LIBOR to SOFR on July 26, 2021. The ARRC will be in a position to formally recommend Term SOFR upon the adoption of this change in trading conventions by market participants.
Background
In our article from April 9, 2021, we detailed the most recent changes to the ARRC's recommended USD LIBOR transition hardwired fallback language. One of the recent updates to the recommended language was the creation of the definition of Benchmark Replacement Rate, which sets out a benchmark replacement waterfall for the transition from USD LIBOR to a SOFR-based rate. If a benchmark transition were to occur today, Term SOFR (the first step in the benchmark replacement waterfall) would be skipped over and the first option for a SOFR-based alternative rate would be Daily Simple SOFR. This is because Term SOFR is not yet a recommended benchmark replacement rate.
Market indicators
On May 6, 2021, the ARRC published the market indicators for the recommended use of Term SOFR. These indicators are designed to measure progress in establishing deep and liquid SOFR derivatives and cash markets, which are essential to a robust and stable Term SOFR rate. The market indicators are as follows:
- Continued growth in overnight SOFR-linked derivatives volumes
- Visible progress to deepen SOFR derivatives liquidity, consistent with ARRC best practices:
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- Offering electronic market-making and execution in SOFR swaps and swap spreads
- Changing the market convention for quoting USD derivative contracts from LIBOR to SOFR
- Making markets in SOFR-linked interest rate volatility products (including swaps, caps and floors)
- Visible growth in offering of cash products, including loans, linked to averages of SOFR, either in advance or in arrears
Recommendation of CME Group as the Term SOFR administrator
As the market indicators were being met, the ARRC began its process for selecting an administrator for Term SOFR. After completing a request for proposals and reviewing various interested candidates, the ARRC announced on May 21, 2021 that it plans to recommend the CME Group as the Term SOFR administrator. The ARRC evaluated the proposals based on four specific criteria: technical, firm criteria, public policy , and calculation of methodology. The ARRC conclusively identified CME Group's proposal as having most effectively met those criteria. In the same May 21, 2021 announcement, the ARRC confirmed that the selection of CME Group as the strongest proposal for the Term SOFR administrator leaves just one step left before Term SOFR becomes available – the formal recommendation of the use of Term SOFR by the ARRC. To do this, the market indicators must all be met.
The final market indicator and the upcoming formal recommendation of Term SOFR
In the ARRC's June 8, 2021 publication, they announced the expected timing for when the market indicators would be met. The Interest Rate Benchmark Reform Subcommittee announced on June 8, 2021 that it recommends, as a market best practice, that interdealer brokers change USD linear swap trading conventions from USD LIBOR to SOFR on July 26, 2021. The ARRC noted in its June 8, 2021 announcement that the Subcommittee's recommendation provides market participants with important guidance that will help accelerate the interest rate swap market's shift away from LIBOR. Provided that market participants support the recommended date, this transition will increase the volume of transactions quoted in SOFR, and thus fulfill the final market indicator for the implementation of Term SOFR. Accordingly, the ARRC confirmed that Term SOFR would be available upon the implementation of the change in quoting (or trading) conventions, removing the last obstacle to using Term SOFR as a benchmark replacement rate. The ARRC finally confirmed that upon the satisfaction of the market indicators, they will be in a position to formally recommend the use of Term SOFR as a robust and stable benchmark replacement rate.
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