ARRC consultation on spread adjustments for fallbacks in cash products referencing USD LIBOR

April 3, 2020 Chatham Financial

Chatham Financial Corporation (Chatham) appreciates the efforts of the Alternative Reference Rates Committee (ARRC) to provide fallback methodologies and recommendations for USD LIBOR upon its permanent discontinuation. Chatham is committed to guiding our clients through a transition to market transaction-based rates, as appropriate; and in the interim, we recognize the need to adopt refined fallback definitions to prudently manage the period during which continued utilization of legacy rates will remain unavoidable for many of our clients. Chatham thanks the ARRC for the opportunity to comment on this consultation on “Spread Adjustment Methodologies for Fallbacks in Cash Products Referencing USD LIBOR.”

Chatham Financial is the largest independent financial risk management advisory and technology firm. A leader in debt and derivative solutions, Chatham provides clients with access to in-depth knowledge, innovative tools, and an incomparable team of nearly 700 employees to help mitigate risks associated with interest rate, foreign currency, and commodity exposures. Founded in 1991, Chatham serves more than 3,000 companies across a wide range of industries — handling over $750 billion in transaction volume annually and helping businesses maximize their value in the capital markets, every day.

For more than two decades, Chatham has invested in creating proprietary models and independently gathering data to value debt and derivatives. Our best-in-class valuation models have been tested and reviewed by auditors from leading accounting firms, providing a thorough calculation of nonperformance risk for clients needing ASC 820 or IFRS 13 fair values. Chatham incorporates industry-leading modern CVA-DVA-FVA and OIS discounting techniques into valuation methodologies.

Chatham offers the following comments in response to the questions in the consultation. Our comments reflect our inherent orientation toward the interests and concerns of derivatives end users, the core constituency of our client base.

Responses to questions

Questions 1- 7 refer to Floating Rate Notes, Securitizations, and Business Loans

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?

If the ARRC does provide recommended spread adjustments, Chatham agrees that using the ISDA methodology of a 5-year median of the historical difference between LIBOR and the SOFR fallback rate is the best method. The historic mean/median approach aims to capture the cyclical nature of markets and, over time, revert to the mean. Therefore, it is important to understand the relevant time scales for the market to complete a cycle. After the recent financial crisis, it took more than 5 years for markets to stabilize. Even today, many markets remain in an unusual position of low interest rates. While a 10-year lookback would be attractive due to its inclusivity of different market regimes, Chatham believes that it is difficult to properly test a 10-year lookback due to the presence of the Financial Crisis and lack of longer-term data. Testing with the data currently available would give too much weight to the crisis relative to the rest of the 10-year lookback period. If more historical data were available, it is likely the lookback would result in a more stable and accurate credit spread. Given the limitations of the historic data, however, Chatham recommends the use of the 5-year lookback period to better capture the weight of events and exclude the 2008 Financial Crisis in the historic lookback period. Chatham recommends using the historic median. In our historic scenario analysis, which is detailed in Section 2.2.2 of our response to ISDA's July 2018 Consultation, the median historic credit spread resulted in fallback rates that were more similar to the replaced IBORs across currencies and different historic averaging lengths.

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:

a. 5-year trimmed mean                               f. 3.5-year median

b. 5-year average                                             g. 3.5-year trimmed mean

c. 10-year median                                            h. 3.5-year average

d. 10-year trimmed mean                            i. Other (please specify)

e. 10-year average

Chatham did not select another method other than the 5-year median approach in Question 1.

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:
a. Use the longest span of indicative term rate data available
b. Use 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.
c. Use the spread between LIBOR and EFFR OIS rates, adjusted for the mean difference between compound averages of EFFR and SOFR

If there are fewer than five years of available data in calculating a spread adjustment for a forward-looking term rate, then Chatham’s preference is to (a) use the longest span of indicative term rate data available. Our second preference is for method (c). We do not believe method (b) is viable given the ARRC’s waterfall for a fallback rate.

Method (a) directly calculates the LIBOR to SOFR forward term rate spread given the available data. There is currently almost two years’ worth of indicative daily forward-looking term data, and we expect to have about three and a half years of daily forward-looking term data to calculate the spread.

ISDA chose to use five years of data in calculating the historic spread, because it performed best in minimizing the error between LIBOR and the fallback rate. Although three and a half years of data performed slightly worse, it did not perform significantly worse. Due to limited data available, no direct calculation is possible to find the optimal spread adjustment associated with a forward-looking SOFR term rate. Given that there is no direct way to measure if five years of data is the best length of time, and three and a half  years worked reasonably well for the historic spread, we believe that 3.5 years will be a reasonable amount of data to use in this case.

The forward term rate and the forward spread data is also calculated from a relatively robust futures market. The SOFR futures market is much smaller than the Eurodollar futures market. However, the $100B of SOFR futures notional traded on average every day appears robust enough for use in USD cash product fallbacks.

Although not our primary choice, method (c) is also a reasonable alternative. It is well known that the EFFR is a fair proxy for SOFR, so an adjusted mean accounting for the average difference between EFFR and SOFR would be an even better proxy. Since it is a proxy and not actually measuring SOFR, however, we rank method (c)below method (a) which actually uses forward SOFR. Additionally, given its additional complexity, method (c) would likely be a more challenging method for the market to adopt. The benefit of method (c) is that we have more data available than in method (a), albeit proxy data. As stated above, however, we do not see this as a significant reason to use method (c) over method (a).

Finally, it is our view that method (b) should be eliminated from consideration as a method in calculating the spread adjustment associated with a forward-looking term rate. Method (b) does involve a reasonable proxy of the SOFR forward rate, however, when viewed in the context of the ARRC’s waterfall for fallbacks, method (b) fails to keep the steps in the waterfall for fallback rates distinct. Method (b) would effectively set the forward rate step in the waterfall equal to the historic rate step in the waterfall. In our view method (b) should not be considered as a possible method in calculating the forward rate spread unless the ARRC is considering removing the forward rate method as a distinct option.

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.)

A transitional period should not be included. A transitional period is a mechanism that allows the LIBOR fallback rate to transition from the LIBOR rate on the date of the discontinuation to a historic average after one year. Chatham believes this transitional period is too long, does not reflect actual LIBOR movements and that there are other potential transition mechanisms. Looking at the history of LIBOR spreads, the spread returns to its average over a period of a few months. As an example, see the historic spread between 3M USD LIBOR and term adjusted SOFR.

Historical basis point

Movements in the spread typically take a few months to return to a more long-term value. The spike that occurred during the 2008 Financial Crisis would not be accounted for by a transitional period because it took more than two years to return to its long-term value.

Chatham also believes that the transitional period allows for market speculation around the proposed discontinuation date. Given the discontinuation date is approximately known, speculators may try to manipulate the spot spread around the discontinuation date. In this case, a speculative spread would be locked in and effect payments for the following year.

Not including a transitional period means that, on the discontinuation date, there may be a jump from the LIBOR rate to the LIBOR fallback rate. Because LIBOR is already a model-driven rate, it is also possible that the LIBOR submissions will drift to the LIBOR fallback rates in the period before the discontinuation. By not including a transitional period, the LIBOR submission process may naturally provide a smooth transition on the transition date.

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

Although these tenors may not be as widely used as the longer-dated tenors, they are used in the market and will require fallback terms. Therefore, if the ARRC provides recommended spread adjustments for other tenors, it should also recommend them for 1-week and overnight LIBOR. Chatham recognizes that the spread adjustments for these tenors will likely be small, but it is important to be consistent across all tenors.

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

Chatham believes the ARRC should not recommend spread adjustments based on simple averages in addition to compound averages. Compounding reflects the time value of money, and this notion should be the standard. While the differences between simple and compound rates have not been large, and simple interest rate averages have been used in the past, it would be better to use rates that accurately reflect how prices work.

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.

There are potential problems with using different fallback methods across different products and currencies, specifically the operational challenge of tracking multiple different spread adjustment methodologies. All things considered, however, minimizing value transfer in order to preserve the economics of the original agreement is a higher priority than the operational challenge of managing inconsistencies across fallback methods.

Chatham does not advise our clients on consumer products; therefore, questions 8-11 have intentionally been omitted.


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