The derivative and cash markets in the US are heading toward the adoption of very different approaches to calculate the new rate to replace London interbank offering rate (Libor), an outcome that could present borrowers with significant hedging and operational challenges. And because of a lack of feedback from commercial borrowers, this is increasing the risk that the solutions regulators decide upon will not fit borrowers’ needs.
The compounded setting in arrears rate referred to by ISDA is set at the end of the term or reset period, whereas as term rate such as Libor is set at the beginning. Eric Juzenas, director of global compliance and regulation at Chatham Financial, said that the compounded setting in arrears rate “may be closer in behavior to a term rate. However, he said, it still presents operational difficulties in terms of cash management and the fact that the term and compounded rate structures are different.”
He added that the ARRC’s and ISDA’s fallback language proposed in consultations is voluntary, and that companies can individually negotiate fallbacks as well the type of SOFR rates for their loans and hedges, whether term or compounded. To make those decisions, however, will require analyzing the practical impact.
“End users need to begin focusing on the practical implications of these rate choices and whether or not regulators are going to pressure dealers to support one rate over another rather than let the markets evolve,” Mr. Juzenas said. “SOFR has been created largely in response to regulatory pressure, it remains to be seen what Libor successors will best match market needs.”