Financial Interest Rate Transition Update: CFTC Chairman Behnam Provides Update on SOFR Implementation

As of June 30, 2023, the target date for the replacement of LIBOR, nears, there is a growing acceptance of alternative benchmark rates for financial contracts.  That was the message to a Bloomberg-sponsored event of Chairman Rostin Behnam, the head of the Commodity Futures Trading Commission (the “CFTC”), an independent agency of the US government that regulates the futures and options markets.

The Secured Overnight Financing Rate or SOFR, which is the risk-free rate for U.S. dollar-denominated financial instruments, is a fully transactions-based rate with the widest coverage of any U.S. Treasury repurchase rate available.  In his remarks, Chairman Behnam noted that the daily transaction volume underlying SOFR often has exceeded $1 trillion and it has never been less than $700 billion, reflecting “activity undertaken by diverse types of institutions, including asset managers, banks, corporate treasurers, insurance companies, money market funds, pension funds and others.”

In the U.S., the Alternative Reference Rates Committee (“ARRC”), the New York Federal Reserve Bank and the CFTC’s Benchmark Subcommittee successfully formulated what Behnam described as “plain English” disclosures that market participants can use to inform clients and counterparties about the implications of continuing to transact in derivatives referencing LIBOR and other legacy benchmark rates.

Another recent initiative was the CFTC’s SOFR Subcommittee’s recommendation for SOFR First, a recommended market best practice for switching trading conventions from LIBOR to SOFR for USD linear interest rate swaps, cross currency swaps, non-linear derivatives and exchange traded derivatives.

The CFTC oversees the futures and options markets in the United States.  These markets are used to trade contracts for the purchase or sale of commodities, such as oil, gold and wheat. Financial futures and options contracts are also transacted on these markets.  Working to enhance fairness and transparency in the trading of these financial products, the CFTC works to protect market participants from fraud and manipulation.

The CFTC also regulates the activities of commodity trading advisors (“CTAs”), commodity pool operators (“CPOs”) and futures commission merchants (“FCMs”).  CTAs provide advice to traders and investors about trading strategies and commodities markets.  CPOs operate commodity pools, which are investment vehicles that pool the resources of many investors to trade commodities.  FCMs are firms that execute trades on behalf of their clients and offer other services, such as clearing and financing.

Chairman Behnam also described an August 2022 CFTC final rule modifying its interest rate swap clearing requirement to remove certain clearing requirements tied to LIBOR and other interbank offered rates and replacing them with similar clearing requirements for swaps referencing overnight, nearly risk-free reference rates.

With progress made on transition and conversion issues for cleared swaps and Eurodollar futures and options, Chairman Behnam pointed to issue areas where concerns remain:  “(1) the transition of legacy LIBOR contracts, particularly legacy LIBOR loans and (2) anchoring the transition in overnight SOFR and limiting the use of Term SOFR rates.”

To promote a smooth and orderly SOFR-related transition, ARRC established fallback language for cash products and securitizations.  Meanwhile, the International Swaps and Derivatives Association established a fallback protocol for derivatives.  Federal legislation passed this year, Chairman Behnam asserted, addresses the risks posed by older LIBOR contracts that do not have workable fallback language, which are also known as tough legacy contracts.  It also provides a safe harbor to lenders if they choose SOFR in contracts where a party has the discretion to select a successor rate.

The Board of Governors of the Federal Reserve System, according to Chairman Behnam, “is preparing a final rule(s) implementing the federal legislation.  While there is much in the works, a high volume of legacy USD LIBOR contracts remains and waiting until June 30, 2023 to transition is untenable.”

On the issue of Term SOFR rates, many loan facilities have adopted them.  As Chairman Behnam noted in his remarks, “ARRC has recognized the use of Term SOFR Rates in certain instances such as the transition of business loans, but has recommended and emphasized that overnight SOFR in advance or in arrears be used for derivatives and non-loan cash products in order to promote financial stability.”

Cautioning against the use of Term SOFR rates in derivatives and most other cash markets, Chairman Behnam referred to “a rather large securitization that referenced Term SOFR” and the concerns it generated.  If this practice were to begin trending, “it would increase the use of  Term SOFR derivatives, which could lead to a decline in the overnight SOFR derivatives markets on which Term SOFR is based.  This outcome would be the antithesis of what the official sector and market participants have worked so hard to achieve.”  For Chairman Behnam, it is important that the use of SOFR, Term SOFR and any other reference rates continue to align with the recommendations of ARRC, the Federal Reserve and the Financial Stability Oversight Council.