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Response to ARRC’s consultation on potential spread adjustments

By

Via electronic email
Mr. Thomas G. Wipf
Chair – Alternative Reference Rates Committee
Federal Reserve Bank of New York
33 Liberty Street
New York, NY 10045
[email protected]

Dear Chairman Wipf,

SOFR Academy is an American education technology firm founded by a team of experienced Financial Services professionals. We utilize learning management software to deliver high-quality and low-cost online training courses dedicated to helping people transition away from the USD London Interbank Offered Rate (LIBOR). We believe that education is critical in order to achieve an orderly and broad-based transition to Alternative Reference Rates (ARR). We also believe that the Secured Overnight Financing Rate (SOFR) can and should be the primary ARR for the significant majority of financial products that currently reference USD LIBOR in the United States of America and abroad.

SOFR Academy is pleased to provide feedback in response to the Alternative Reference Rate Committee’s (ARRC) important consultation on potential spread adjustment methodologies to account for the differences between SOFR and USD LIBOR. SOFR Academy informally discussed preferences and responses with selected organizations, infrastructure providers and end users in forming our views on this consultation. Please find feedback in response to each specific question in the consultation below.

Question 1. Do you agree that using the ISDA methodology of a 5-year median of the historical difference between LIBOR and the SOFR fallback rate is the best choice for the following cash products, or would you prefer an alternative method?

SOFR Academy supports the use of the 5-year median of the historical difference between LIBOR and the SOFR fallback rate for Floating Rate Notes, Securitizations, Syndicated Loans and Bilateral Business Loans.

Question 2. If “Other Method” was specified for any product, please provide additional feedback on your institution’s preferences, noting whether your alternative is strongly or mildly preferred and why you prefer the alternative method.

The five-year median is preferred for Floating Rate Notes, Securitizations, Syndicated Loans and Bilateral Business Loans

Question 3. If there are fewer than 5 years of available data to use in calculating a spread adjustment for a forward-looking term rate, which method would you prefer to calculate the associated spread adjustment. 

SOFR Academy advocates for the use of the spread adjustment associated with the difference between LIBOR and a compound average of SOFR in arrears as an appropriate spread adjustment for the forward-looking term rate if there are fewer than five years of available data to use in calculating a spread adjustment for a forward-looking term rate.

Question 4. Do you believe that a 1-year transition period should be included for any of these cash products? If yes, please specify which products. (If you believe that a transition period should be included, but that it should be longer or shorter than 1 year, please note this and explain why.)

SOFR Academy notes the importance of the ARRC in receiving broad based feedback from a relatively large and diverse number of respondents as being imperative in order to arrive at a balanced and informed view on this question. Despite our best efforts we were unable to obtain a clear consensus on this question however we wanted to offer some related thoughts:

  • Based on informal conversations with IBOR transition program leaders at selected organizations (including Treasurers, Chief Risk Officers and IBOR Program Management Office leads), two of the most common concerns for the transition away from LIBOR are (1) the minimization of potential interest basis risk and (2) the minimization of potential litigation risk. We believe that a one-year transition period could create additional operational complexity for market participants by increasingly the likelihood of transitional interest rate basis risk but at the same time could reduce potential litigation risk. Conversely, if a transition period was not allowed for and a legislative solution was not in place then we view the likelihood of potential litigation and class actions as being higher.
  • SOFR Academy notes that the general characteristics of market participants in cash products that currently reference USD LIBOR can differ across floating rates Notes (~$1.8 Trillion), business Loans (~$3.4 Trillion) and securitized products (~$1.5 Trillion). Larger and more sophisticated Financial Institutions are generally better equipped than smaller firms to manage potential resultant interest rate basis risk for any potential transition period where a multi-rate environment was required.
  • SOFR Academy acknowledges and supports the ARRC’s Guiding Principle “to minimize expected value transfer based on observable, objective rules determined in advance”[1] however we believe the likelihood of achieving a zero-value transfer (net-present value neutral) in operational reality is probably low. SOFR Academy also notes the potential for unintended macroeconomic and credit implications, particularly in the United States, resulting from an all in SOFR, adjusted for term and credit premium(s), being higher or lower than existing LIBOR based rates at the time that contract fallback language took effect.
  • SOFR Academy also notes that a number of market participants that transact in cash products have recently had to divert their attention and resources to addressing business continuity related issues in connection with the coronavirus (COVID-19) pandemic. Further, there is uncertainty on how long this disruption will persist which supports the need for additional time to adequately prepare to transition away from LIBOR.

Question 5. Should the ARRC recommend spread adjustments for 1-week or overnight LIBOR?

Although we do not see a large number of market participants referencing LIBOR in these shorter tenors, we cannot rule out a need for spread adjustments in these tenors nor can we see a valid reason why spread adjustments for these terms should not be recommended and made available using methodologies consistent with responses from previous LIBOR transition related industry consultations.

Question 6. Should the ARRC recommend spread adjustments based on the differences between LIBOR simple averages of SOFR in addition to compound averages?

Although SOFR Academy views the recent publication of SOFR Averages by the Federal Reserve Bank of New York as a positive step and generally supportive of the overall transition away from LIBOR, at this time our client conversations indicate that the practical applications of SOFR Averages remain limited.

Question 7. Would it be problematic to use different approaches to calculate the spread adjustment across products and currencies? Please comment specifically on the implications of any differences in the recommended spread adjustment methodologies.

SOFR Academy supports consistency in approaches and methodologies across products and currencies where possible.

SOFR Academy believes that there continues to be an opportunity to strengthen cross-jurisdictional dialogue and inter-National Risk-Free Rate working group communication and co-ordination. In terms of an example, SOFR Academy believes that the likelihood of potential legislation to address ‘Tough Legacy’[2] contracts has increased in both the United Kingdom and at the New York State level[3]  – consistency and co-ordination where possible in terms of the content of the potential legislation would probably make sense, especially as it impacts multinational financial institutions.

Questions 8 – 11 refer to Consumer Products

Question 8. Do you agree that using the ISDA methodology of a 5-year median of the historical difference between LIBOR and the SOFR fallback rate is an acceptable choice for consumer products, or would you prefer an alternative method? (If another method is preferred, please specify which and note whether your alternative is strongly or mildly preferred and why you prefer the alternative method).

SOFR Academy is supportive of using the ISDA methodology of a 5-year median of the historical difference between LIBOR and the SOFR fallback rate for consumer products. We generally are supportive of most outcomes that help to minimize interest rate basis risk.

Question 9. Do you believe that a 1-year transition period should be included for consumer products? (If you believe that a transition period should be included, but that it should be longer or shorter than 1 year, please note this and explain why).

SOFR Academy echoes recent calls from certain industry associations[4] to support a transition period of at least 1 year for consumer products. We also wanted to offer some related thoughts:

  • SOFR Academy notes that research from the Official sector indicates that the consumer product segment of the United States economy is disproportionately sensitive to adverse interest rate shocks meaning that even relatively small increases in interest rates can cause significant financial hardship for this sector. SOFR Academy acknowledges the importance of the ARRC in forming views and making decisions on LIBOR transition for the consumer segment in close partnership and cooperation with the relevant domestic consumer advocacy groups.
  • As previously noted in response to Question 4, uncertainty relating to the national emergency caused by the coronavirus (COVID-19) pandemic is creating meaningful uncertainty in the consumer products segment from both the lender and the borrower’s perspective. It is currently unknown how long this uncertainty will persist which supports the need for an additional transitional period.

Question 11. If there is less than 5 years of available data to use in calculating a spread adjustment for a forward-looking term rate, which method would you prefer to calculate the associated spread adjustment.

SOFR Academy supports the use of the spread adjustment associated with the difference between LIBOR and a compound average of SOFR in arrears as an appropriate spread adjustment for the forward-looking term rate.

Question 12 applies to all products

Question 12. Please provide any additional feedback on any aspect of the proposals.

SOFR Academy supports recent calls from certain market participants to bring forward the timing of the publication of forward-looking term version of the SOFR[5]. We understand that there are barriers that exist to being able to achieve this however we would like to add our support to intensify industry efforts in this regard as we believe this would be a significant enabler for the market transition.

LIBOR transition is one of the most significant and complex changes impacting financial services and the global financial market over the next few years. SOFR Academy acknowledges and applauds the significant amount of work that the ARRC and its sub-working groups have accomplished thus far. Further, it is a fact that the US Dollar is still the world’s most important reserve currency which underscores the significance of the work of the ARRC. SOFR Academy is committed to supporting the objectives of the ARRC in order to achieve an orderly and broad-based transition for both Wall Street and Main Street market participants.

Thank you for your consideration of these comments.

Yours sincerely,
Members of the Management Board.

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