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ARRC Issues Updates to Term SOFR Best Practice Recommendations
Practical Law Legal Update w-039-2776 (Approx. 5 pages)
ARRC Issues Updates to Term SOFR Best Practice Recommendations
by Practical Law Finance
| Published on 27 Apr 2023 • England, USA (National/Federal), Wales |
The Alternative Reference Rates Committee (ARRC) issued an update that summarizes and revises its best practice recommendations on the use of CME Group’s Term Secured Overnight Financing Rate (Term SOFR) endorsed by ARRC in July 2021.
On April 21, 2023, the Alternative Reference Rates Committee (ARRC) issued an update that summarizes and revises best-practice recommendations on the use of the Term Secured Overnight Financing Rate (Term SOFR) it issued in July 2021 (see Legal Update, ARRC Issues Update on Upcoming Formal Recommendation for Term SOFR). The purpose of the update is to:
- Increase business-loan market participants' understanding of the risks in hedging Term SOFR.
- Clarify definitions related to Term SOFR to support its long-term usefulness in the market.
The update provides clarifications and definitions that support its position that Term SOFR should be used as a fallback with legacy LIBOR cash products, new business loans, and securitizations holding legacy LIBOR products or new business loans referencing Term SOFR (see Legal Update, FSOC Annual Review Identifies Primary Risks to US Financial System).
Loans and securitizations. The ARRC updates include clarifications that:
- An intercompany loan is any loan or other extension of credit by a company to any affiliate or subsidiary of the company or by an affiliate or subsidiary of a company to the company or to another affiliate or subsidiary of the company.
- A business loan is a loan or other extension of credit that is primarily for business or commercial purposes and includes but is not limited to, whether or not syndicated to banks or other financial entities in each case: commercial loans; corporate loans; middle market loans; trade finance transactions including receivables finance/purchases and discounting; Islamic financing or lease facilities; and loans or other extensions of credit for business or other governmental purposes to nonprofit enterprises, municipalities, or other governmental or public entities.
- A business loan does not include a securitization, credit transaction to a consumer, security (whether offered publicly, offered under Rule 144A, or any other security, unless such security is a loan or other extension of credit or the functional equivalent of a loan or other extension of credit of the type described in the update's definition of business loan, noted above), swap agreement, intercompany loan, or any advance made by a Federal Home Loan Bank.
- A securitization is considered to have Term SOFR assets if it is collateralized or serviced by assets that include self-liquidating or revolving cash-product assets that pay Term SOFR and allow the securitization holder to receive cash flow contingent payments from those Term SOFR assets.
Derivatives. In addressing derivatives, ARRC notes the risk that dealers may accumulate large one-sided Term SOFR positions that may hinder their ability to write further Term SOFR derivative business for end users. This risk could increase the cost of hedging Term SOFR to a prohibitive extent.
To the address this, the ARRC provides:
- Definitions of market-making and non-market making dealers:
- a market-making dealer is any dealer that makes two-way prices in interest rate derivatives and is a market maker in the interdealer market for these derivatives in the regular course of business; and
- a non-market making dealer is any other dealer that satisfies the definition of market-making dealer.
- That a dealer may enter into Term SOFR basis swaps with any non-dealer market participant, even if the market participant is not a direct party to a Term SOFR cash exposure.
An end user of Term SOFR is defined as a direct party to:
- A new Term SOFR business loan; or
- A securitization linked to Term SOFR assets, or to a legacy LIBOR product that has converted to the Term SOFR through contractual fallback language or legislation.