The LIBOR transition process is an affair of headache-inducing complexity. Amidst the thousands of gallons of ink spilled on the subject, we thought it might be useful, from time to time, to give you some important information in bite-sized servings (don’t worry, we will continue to publish lengthy, irreverent commentaries on the subject that our long-time readers have come to expect). So here’s your first Quick Note. What will the Alternative Reference Rates Committee (“ARRC”) recommend for the spread adjustment?
When LIBOR goes away, everyone expects that LIBOR will be replaced with some other floating rate benchmark plus a spread adjustment. One of the biggest open questions in the LIBOR transition process is how that spread adjustment will be determined. Whatever the ARRC recommends will carry a lot of weight in the market, especially for prudentially regulated institutions. We know that the ARRC is committed to recommending a spread adjustment but their consultation on the subject is not yet available. According to the ARRC’s paced transition plan, we can expect that consultation by the end of the year.
The ARRC’s September meeting minutes give some hints at what to expect the ARRC’s recommendations to look like. While the ARRC will take into consideration whatever spread adjustment the International Swaps and Derivatives Association (“ISDA”) implements in the derivatives markets, it is clear that the ARRC will not automatically recommend what the ISDA chooses. This might result in a mismatch between the derivatives markets and the cash products markets. That said, data presented by researchers from the Federal Reserve Bank of New York during the ARRC meeting seems to favor determining the spread adjustment by taking a “trimmed mean” of the difference between LIBOR and the applicable LIBOR replacement over a ten-year lookback period. If the LIBOR replacement is based on SOFR, this would require the use of a proxy rate since published SOFR is less than two years old. Notably, this method of determining the spread adjustment is pretty similar to one of the two options currently under consideration by the ISDA in its Consultation on Final Parameters for the Spread and Term Adjustments in Derivatives Fallbacks for Key IBORs. We don’t yet know if the ARRC will recommend any dynamic element to the spread adjustment to capture the changing market-participant risk that LIBOR has and SOFR does not—currently it seems unlikely.