On August 27, 2021 the Alternative Reference Rates Committee (ARRC) issued FAQs and related best practice recommendations as a follow-up to its formal July 29, 2021 announcement of its recommendation of forward-looking Secured Overnight Financing Rate (SOFR) term rates (see Legal Update, ARRC Formally Recommends Forward-Looking SOFR Term Rate).

The ARRC restates in the FAQs its prior support for the use of term SOFR for end-user-facing derivatives intended to hedge cash products that reference the SOFR term rate. The FAQs state that for these purposes, the ARRC considers an end user to be:

The FAQs state that a dealer counterparty to these end-user hedges would not be considered an end user, and that the ARRC expressly does not recommend a dealer seeking to hedge its own resulting SOFR term rate exposure with an additional SOFR term rate derivative.

The ARRC recognizes in the FAQs that bank treasury or lending desks may sometimes rely on an affiliated dealer to execute the bank's derivatives hedges with third-party swap dealers to hedge a SOFR term rate cash product to which the bank is a direct party. Such arrangements are viewed under the FAQs as part of the bank’s hedging activities as the end user to an underlying cash term SOFR position. The FAQs observe that in accordance with hedge accounting standards, this bank derivative with the third-party dealer must remain outstanding for the duration of the hedge of the term SOFR cash products and may not be risk-managed through compression, offsetting, or other means by the affiliate dealer.

The FAQs also note, however, that the dealer counterparty to these bank hedges could hedge its own exposure using derivatives linked to forms of overnight SOFR, consistent with the ARRC’s existing recommendation that overnight SOFR and SOFR averages be used in cases where a party wishes to hedge in an efficient and transparent manner.

The ARRC reiterates that the use of the SOFR term rates for the vast majority of the derivatives markets is not supported by the ARRC because these markets already reference SOFR compounded in arrears and transitioning derivatives markets to the more robust overnight risk-free rates (RFRs) is essential to ensure financial stability (see Legal Update, ARRC Issues Update on Upcoming Formal Recommendation for Term SOFR).

For further information on LIBOR replacement, see Practical Law's LIBOR Replacement Toolkit.