This blog was co-authored with Rory Scott and Lara Thom, Candidate Attorney’s
In 2017, the Alternative Reference Rates Committee (ARRC) recommended the replacement of LIBOR with the Secured Overnight Financing Rate (SOFR). Since the proposed transition, developing markets have been rudderless regarding which benchmarks to apply.
There are four types of SOFR that apply to cash products:
- forward-looking Term SOFR (most similar to LIBOR);
- SOFR compounded in advance (backward looking daily rate observed over a specific period of time before the beginning of the interest period);
- SOFR compounded in arrears (backward looking daily rate observed during the interest period); and
- Simple daily SOFR in arrears (backward looking rate that accrued during the interest period).
Term SOFR, unlike any form of daily SOFR, is a forward-looking term rate. The rate represents the cost of overnight borrowing in the US Treasury repo market.
The interest rate for Term SOFR is calculated at the start of an interest period for the duration of the term to which it is applied (whether one, three, six or twelve months). This differs from compound and daily simple SOFR in which the interest is calculated at the end of the interest period.
In developing markets, new transactions are increasingly being based on Term SOFR because of the certainty Term SOFR provides to borrowers. Borrowers are aware from the outset of the interest period and what their interest payment will be. Term SOFR has the same look and feel of USD LIBOR, except that USD LIBOR is a bank panel-based estimate, whereas, Term SOFR is calculated based on hard historical data (and then applied forward). Because Term SOFR is forward looking, it grants borrowers a degree of familiarity with what they have become used to, on account of the entrenched use of USD LIBOR over many past decades. This has resulted in Term SOFR being used enthusiastically in the U.S. loans market, and has led to the majority of new deals being based on Term SOFR as opposed to daily SOFR or compounded SOFR.
The ARRC, which is organised by the Federal Reserve Bank of New York) continues to recommend Term SOFR for new contracts. Term SOFR has specifically been recommended for use in markets where securitisations are present. Term SOFR is currently quoted for 1-month, 3–month, 6-month and 12-month tenors.
Outside of the US and in developing markets, there has been a slower uptake to the use of SOFR. Compounded SOFR remains popular as the predominant benchmark for USD, but Term SOFR is increasingly being used. The Loan Market Association has begun drafting agreements which incorporate the use of Term SOFR.
Because Term SOFR is forward-looking, more familiar to the market, easier to use, and with the Loan Market Association having provided draft agreements for its implementation, Term SOFR is likely to become the leading benchmark for USD lending in developing markets.
