ARRC’s trivial fight over term SOFR use

On November 8, Toyota issued a $1.5 billion auto loan securitisation with a $293 million floating rate tranche linked to a term version of the secured overnight financing rate, or SOFR.

It seemed innocuous enough, but the deal rankled members of the Alternative Reference Rates Committee, the Federal Reserve-backed group tasked with steering US markets away from Libor, which had previously advised against the use of term SOFR in securitisations of fixed rate assets such as auto loans.

The timing could not have been worse. At a meeting the following day, the ARRC was set to consider a proposal to expand the use of term SOFR in derivatives. But the meeting was derailed by debate over the Toyota deal. The plan to allow a wider use of term SOFR in derivatives was shelved for another day.

That has not gone down well with the market. One structured finance banker dismissed the spat over the Toyota deal as “a big hullaballoo” that is distracting from the industry’s wider goals.

The ARRC endorsed CME’s term SOFR last year, subject to a set of usage guidelines, to aid the market transition away from Libor. The problem, market participants say, is that the ARRC guidelines and CME’s terms of use don’t quite match up.

While both are clear the rate can only be used in derivatives that directly hedge cash instruments that reference term SOFR, the rules are far less clear when it comes to the cash instruments themselves.

CME’s 14-page licensing agreement allows term SOFR to be used in all sorts of cash products, including “loans, mortgages, bonds, money market instruments (including certificates of deposit and commercial paper), cash securities, preferred stock, floating rate notes, structured notes, bank notes, capital or deposit instruments and any other debt or credit instruments”.

“That’s pretty expansive,” says a London-based lawyer, noting that securitisations fall within the structured notes definition. “The licence allows you to use it as you like for cash products.”

The ARRC’s three-page best practice guidance limits the use of term SOFR to business loans and certain securitisations “that hold underlying business loans or other assets that reference the SOFR term rate and where those assets cannot easily reference other forms of SOFR”.

The ARRC, though, has no real power to enforce its guidelines. As a Libor transition manager at a US bank says: “These are not restrictions, just recommendations.”

Some say CME should simply revise its licence terms to align with the ARRC’s guidelines. “The market would benefit from that,” says a lawyer in New York, adding that this could be in the form of a clarification rather than a formal change to the licence.

But CME may have good reasons to resist calls for stricter usage terms, which could dent competitiveness and prove costly to monitor and enforce. A spokesperson for the exchange declined to comment.

It’s also worth bearing in mind that CME’s benchmark is not the only game in town. Ice Benchmark Administration, Libor’s administrator, began publishing its own version of term SOFR in April. While Ice’s rate lacks an official endorsement and is not included in the waterfall of replacement rates in ARRC cash fallbacks, it is currently being licensed for use in contracts – both cash and derivatives – without any usage restrictions.

So far, there’s been little interest in this alternative version, which is largely viewed as a redundancy rate for CME’s term SOFR. IBA wasn’t even allowed to use its own rate in a proposed ‘synthetic Libor’, which would be used to sweep in a tail of tough legacy contracts.

CME, by contrast, has issued over 7,000 term SOFR licences to more than 1,800 firms. The rate underpins $2.6 trillion of loans and more than $660 billion of related derivatives hedges.

That doesn’t mean it’s a fait accompli for CME. The ARRC’s restrictions on the use of term SOFR in derivatives have created a one-sided market which dealers warn could pose a stability threat. The furore over the Toyota deal, and the use of term SOFR in securitisations of fixed rate assets more broadly, has faded hopes of softening the derivatives stance.

In the gargantuan multi-year project to prise hundreds of trillions of dollars of contracts off Libor ahead of its June 2023 demise, a fight over the use of term SOFR in floating rate asset-backed securities – which are estimated to represent just 2% of overall issuance – seems trivial at best. Overly tight restrictions on CME term SOFR could gift the market to a non-endorsed competitor. Worse, it could breathe new life into credit-sensitive rates, which regulators fought so hard to extinguish. The ARRC should look past the Toyota deal and refocus on its core objectives.