On July 22, 2021, the Alternative Reference Rates Committee of the Federal Reserve Bank of New York (ARRC) followed up on its guidance from June and its confirmation on July 19 by formally recommending CME Group's forward-looking SOFR term rates. After a roller coaster ride earlier this year, the messaging of the ARRC on Term SOFR settled down. Other than the mystery as to exactly when the announcement would be made, the statement was practically a nonevent. Proactive lenders that have been waiting patiently were quietly preparing their Term SOFR loan forms over the past few weeks. A flurry of new Term SOFR loans should not be far behind.

With this development, it might seem that the market has all the tools that it needs to transition to SOFR. Between daily simple SOFR, compounded SOFR, published SOFR averages and now Term SOFR, there should be a variant of SOFR that works for almost every loan. As the ARRC proclaimed in its statement, the recommendation of Term SOFR marks the completion of the  paced transition plan that it outlined in 2017. Time for high-fives and a victory lap!

Not so fast. As those who have been living through the transition over the past few years can attest, there is always another issue to address. In this case, it's interest rate swaps. In its best practice recommendations on July 21, 2021, the ARRC specifically recommended that use of Term SOFR derivatives be limited to "end-user facing derivatives intended to hedge cash products that reference the SOFR Term Rate." This is ARRC-speak for borrowers hedging their interest rate exposure on loans bearing interest based on Term SOFR.

Great—so loan borrowers can enter into Term SOFR swaps for their Term SOFR loans, right? Not yet. Per CME's terms of use, users of Term SOFR have no right to "create, calculate, issue, settle, maintain, support or develop any financial instruments," including "swaps." For now, Term SOFR is just an interest rate. CME Group offers clearing of compounded SOFR swaps, but that's it so far.

The limitation on Term SOFR swaps is by design. A robust market in regular SOFR loans and swaps is a necessary element to developing Term SOFR and Term SOFR swaps. In recommending Term SOFR, the ARRC merely determined that the minimum conditions to support a forward-looking term rate are present. The SOFR market has a long way to go; expanding Term SOFR too soon could undermine the continued future development that is needed. Market participants that were scrutinizing ARRC statements for signs such as "relatively soon," "soon" and "imminent" will now have to turn their attention to similar statements from CME Group.

Until Term SOFR swaps develop, borrowers will have to hedge their SOFR interest rate exposure with regular SOFR swaps. Unless interest on a particular loan is calculated based on SOFR compounded in arrears (a rarity these days), this will lead to basis risk due to the mismatch between the rate on the loan and the rate on the swap (or the back-to-back hedge that the lender enters into to hedge its exposure on its swap with the borrower). The borrower, the lender providing the swap or both will have to bear this risk. Since the forward-looking term structure of Term SOFR is quite popular in the lending market, it is unlikely that this will be a deal killer to making Term SOFR loans. However, for loans where the borrower wants or needs to hedge its interest rate exposure, it might be easier to use daily SOFR since that rate can be more reliably hedged.

For More Information

If you have any questions about this Alert, please contact Roger S. Chari, Joel N. Ephross, Amelia (Amy) H. Huskins, Phuong (Michelle) Ngo, any of the attorneys in our Banking and Finance Industry Group or the attorney in the firm with whom you are regularly in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.