ARRC Publishes Consultation on Spread Adjustment Methodologies for Cash Products Referencing LIBOR | Practical Law

ARRC Publishes Consultation on Spread Adjustment Methodologies for Cash Products Referencing LIBOR | Practical Law

The Alternative Reference Rates Committee (ARRC) launched a consultation seeking feedback from market participants on the recommended spread adjustment methodologies for cash products referencing LIBOR.

ARRC Publishes Consultation on Spread Adjustment Methodologies for Cash Products Referencing LIBOR

by Practical Law Finance
Published on 03 Feb 2020 • USA (National/Federal)
The Alternative Reference Rates Committee (ARRC) launched a consultation seeking feedback from market participants on the recommended spread adjustment methodologies for cash products referencing LIBOR.
On January 21, 2020, the Alternative Reference Rates Committee (ARRC) published a consultation seeking feedback from market participants on the appropriate spread adjustment methodology that ARRC should recommend as part of its fallback provision recommendations for cash products referencing USD LIBOR.
ARRC's 2018 consultations on fallback provisions (see Legal Updates, ARRC Releases Consultations on LIBOR-Fallback Contract Language for Bilateral Business Loans and Securitizations and ARRC Releases Consultations on LIBOR-Fallback Contract Language for Floating Rate Notes and Syndicated Business Loans) revealed that market participants wanted the ARRC to recommend spread adjustments for these fallback provisions for cash products.
Therefore, ARRC set out to establish a static spread adjustment that would be fixed at a specified time at or before LIBOR’s cessation and would reflect and adjust for the historical differences between LIBOR and the Secured Overnight Financing Rate (SOFR). The ARRC intends to make the spread-adjusted rate comparable to LIBOR in a fair and reasonable way and reduce the economic impact of shifting from an unsecured rate to a rate that is nearly risk-free.
The ARRC notes that the methodology used to determine the spread adjustment for consumer products, such as adjustable rate mortgages, may differ from the methodologies used for other cash products, such as floating rate notes and syndicated loans, given the different expectations in the relevant markets. Following the completion of the consultation process, the ARRC intends to recommend a methodology (or methodologies) for determining the spread adjustment to the SOFR-based fallbacks.
The ARRC acknowledges that the recommended methodology (or methodologies) will produce different spread adjustment amounts for different LIBOR tenors, resulting in distinct recommended spread adjustment calculated for 1-month, 2-month, 3-month, 6-month and 1-year LIBOR. The ARRC spread adjustment recommendation will be used to determine a static spread adjustment amount for each tenor, meaning that the spread adjustment amount will be fixed on a date occurring on or before the date of the occurrence of the related fallback trigger event.
However, the ARRC emphasizes that any spread adjustment that it recommends is only intended for use in LIBOR contracts that have incorporated the ARRC's recommended hardwired fallback language or for legacy LIBOR contracts in which parties have selected an ARRC recommended spread-adjusted rate as a fallback.
The consultation explains the need for a spread adjustment due to the differences between SOFR, which is an overnight, secured, nearly risk-free rate (RFR), while LIBOR is an unsecured rate published with several different maturities. A spread adjustment is intended to be used together with the recommended fallback language for the successor rate at the trigger event. The spread adjustment methodology would be the same across different tenors of LIBOR, but would be applied to each LIBOR tenor separately, to create a different recommended spread adjustment for each tenor of LIBOR.

ARRC Considerations and Analysis

ARRC discusses the following considerations that arise in the search for its recommended spread adjustment methodology:
  • Whether the same methodology and parameters should be used to calculate recommended spread adjustments for:
    • a compound average in arrears;
    • a compound average in advance; and
    • a forward-looking term rate.
  • How the long-run level of the difference between LIBOR and SOFR should be measured.
  • How far back in time data should be reviewed to estimate the long-run level.
  • How quickly the spread adjustment should move to the long-run historical level.
ARRC explains that it uses historical data to help assess potential parameter choices and uses mean absolute errors (MAEs) as summary statistics of the difference, over time, between realized LIBOR rates and the spread-adjusted rates for different hypothetical contracts to assess the historical accuracy of any set of parameter choices. MAE statistics are used to measure the size of differences between LIBOR and the spread-adjusted rate. A smaller MAE value means that the size of the differences is smaller. Although any spread adjustment will have some difference with LIBOR, adjustments that historically would have produced smaller MAEs would be preferred.
In the consultation, the ARRC analyzes various methodologies for determining the spread adjustment, including the methodology proposed by ISDA®. The ARRC points out that maintaining consistency with ISDA's methodology may minimize operational, legal, tax, accounting and other issues between loans, securitizations and notes, and any related hedges.
Recent ISDA consultations have found that respondents support a static spread adjustment for derivatives that will be calculated as the median of the historical difference between a given tenor of USD LIBOR and a compound average of SOFR in arrears over a corresponding tenor.
The median difference will be calculated using the five years of historical data that precede the applicable trigger event. Before these (static) spreads are fixed, Bloomberg will publish daily indicative spreads based on ISDA's adopted methodology. ISDA's current fallback language only includes trigger events related to the cessation of LIBOR. ARRC's fallback recommendations also include a pre-cessation trigger, and ISDA is considering including a pre-cessation trigger as well.

ARRC Conclusions

The consultation includes 15 tables comparing MAEs to help market participants understand the analysis. These tables reflect that:
  • While most respondents to the ARRC consultations prefer to fall back to a forward-looking SOFR term rate, even falling back to a spread-adjusted compound average in advance would not have resulted in larger errors, and in certain cases, might have resulted in smaller errors than a spread-adjusted term rate.
  • Using a simple average usually generated larger errors than using either a median or trimmed mean, and the errors generated using a median or trimmed mean were generally similar.
  • SOFR-based reference rates based on a lookback period of at least five years were found to be closer to the underlying LIBOR reference rates than rates based on a two-year lookback, and lookback periods of two years or less tended to produce less accurate results. ARRC concluded that ISDA's choice of a five-year lookback seemed reasonable since results did not improve appreciably in most cases beyond five years.
  • A transition period was found to be valuable if the last reliable LIBOR rates were at historically wide spreads to other money market rates. A one-year transition period would help mitigate against a "cliff effect" at the time the fallback applies if the LIBOR/SOFR spread at that time differs from the long-term historical spread by moving gradually instead of immediately toward the spread. AARC found that increasing the transition from one year to two years did not show much benefit. The consultation provides an appendix with further technical detail on a transition period. The appendix provides an example to illustrate how a one-year transition period would work.
The ARRC concluded that they have a certain amount of flexibility available in their recommendations on fallback methodologies for legacy contracts. This flexibility may allow the choice of methodology to be influenced by factors such as simplicity of implementation or consistency across instruments.
For the major consumer products, the ARRC is contemplating the publication of a replacement index recommended by either the Federal Reserve Board or the Federal Reserve Bank of New York. The ARRC intends that the publication of a recommended replacement index for the major consumer products will make it easier for consumers to arrive at the index without having to calculate it using the spread adjustment methodology that will be adopted by the ARRC.

Consultation Questions

Following its analysis, ARRC poses questions to market participants seeking responses and will use the feedback it receives to recommend spread adjustments that would apply to its fallback recommendations. Comments must be received no later than March 6, 2020.

ISDA Letters to FCA and IBA

Similar to ARRC, ISDA performed a consultation on pre-cessation fallbacks in 2019, which found that market participants would generally not want to continue referencing LIBOR in existing or new derivatives contracts once it is no longer representative of the underlying market. However, ISDA did not reach a consensus on how to implement pre-cessation fallbacks. Therefore, on January 24, 20120, ISDA published the following letters that provide detail on the length of time that a non-representative LIBOR would be published:
For further information on these letters, see Legal Update, FCA and IBA Respond to ISDA Request to FSB for Clarity in Respect of Implications of Non-Representative LIBOR.

ARRC Vendor Survey

On January 31, 2020, the ARRC released a survey regarding vendor preparedness to transition from LIBOR to SOFR. The ARRC intends for vendors to use the survey:
  • As a self-assessment tool and to share their responses directly with clients.
  • As an opportunity to contribute information to the ARRC about transition readiness and challenges, and to raise awareness about operational changes required for a seamless transition.
Section I of the survey focuses on foundational questions about the transition including:
  • Vendors' understanding of the impact that the transition will have on their products and applications.
  • Key enhancements necessary to ensure product readiness.
  • Financial instruments to which their products or applications pertain.
Section II of the survey is meant to be used by the vendors individually as a self-assessment tool.
The ARRC has asked vendors to send their responses to Section I of the survey to the ARRC by March 25, 2020.
"ISDA" is a registered trademark of the International Swaps and Derivatives Association, Inc. (ISDA). ISDA is not a sponsor of Practical Law and had no part in the development of this Update.