What Index Should Banks Use Now for Hedging and ARC Loans
On October 23, 2020, the International Swaps and Derivatives Association (ISDA) published the Fallback Protocol (Protocol) that allows firms that use LIBOR to transition to SOFR when LIBOR becomes unavailable. On November 30, 2020, ISDA and IBA announced that it will cease publication of the one-week and two-month US dollar LIBOR settings immediately following the LIBOR publication on December 31, 2021. ISDA and IBA further stated that the remaining US dollar LIBOR settings would cease immediately following the LIBOR publication on June 30, 2023. Because our Assumable Rate Conversion (ARC) program uses primarily 1-month LIBOR, ARC customers have until June 30, 2023, to transition those ARC loans to SOFR. What index should existing and new ARC customers consider for their loans/hedges?
Recent regulatory messages have reinforced the importance of market participants preparing for no new LIBOR at the end of 2021. Banks must be ready with systems, vendors, and recommended timelines around discontinuing new LIBOR activity across all products by the end-2021. However, regulators are providing an additional 18 months (to June 2023) to allow participants to focus on the remaining legacy exposures. The Alternative Reference Rates Committee’s proposed guidelines and the ISDA Protocol are an essential part of a smooth transition to SOFR. Banks have a clear path for the wind-down of US dollar LIBOR (end of 2021), and a transition to SOFR on existing instruments by June 30, 2023.
CenterState Bank uses the ARC program for our own borrowers, and we have considered the details of the best options are available to ARC customers for new ARC loans between now and 2021. We have considered this question based on operational, economic, documentation, and marketing perspectives and have concluded the following options based on the order of preference:
Option 1: Banks may continue to use 1-month LIBOR on ARC loans into 2021. The industry anticipates that in Q1 or Q2 2021 a 1-month SOFR tenor will be available, at which point the transition to 1-month SOFR for new loans/hedges will be easy for core systems to input and bill. Banks that have legacy ARC loans tied to LIBOR will transition to SOFR starting after June 2023.
Option 2: Banks may use non-compounding SOFR for new ARC loans. We have tested this option at CenterState, and this option is now available to all ARC customers. It does require that the community bank track a new index (https://apps.newyorkfed.org/markets/autorates/sofr). The downside is that the billing statement cannot be finalized until 2-business days before the borrower’s billing date. Further, when available in Q1 or Q2 2021, banks will strongly prefer a 1-month SOFR index; therefore, banks will then have to track two SOFR rates in their system.
Option 3: Banks may choose another index (such as Prime as an example). However, the industry is moving to create broad and transparent markets for SOFR, and it will be SOFR that gains the best execution and broadest availability. While other indices are available to hedge commercial loans, they suffer from poor execution levels, wider bid/offer spreads, and a narrower set of trading counterparties. These other indices are also daily reset with some unfortunate operational challenges.
Option 4: Finally, banks may use compounding SOFR for new ARC loans. The advantage is that currently, this is the only clearable SOFR hedge index. However, in our discussion with community banks, we have yet to find a core system that will track daily compounding interest rates.
Virtually all ARC transactions have required that both the ARC promissory notes and the Rate Conversion Agreements include fallback language that allowed the lender and CenterState Bank to substitute LIBOR with another index if LIBOR is no longer available or is no longer representative of market-driven rates. However, because under the ARC program the community bank is not a counterparty to the derivative, some banks may find it simpler not to formally adhere to the ISDA Protocol. Therefore, CenterState Bank will ask banks in the ARC program to sign a one-page agreement that will allow both the bank and CenterState to apply the Protocol to all ARC transactions and transition LIBOR to SOFR on the appropriate date. A similar one-page agreement will be provided to the bank to be shared with all ARC borrowers – allowing the borrower and CenterState to apply the ISDA Protocol to all Rate Conversion Agreements.
CenterState will be reaching out to ARC customers with a White Paper, sample borrower correspondence on this subject, and the two documents referenced above. In early 2021, CenterState will host webinars to explain the transition to SOFR, explain the options available to existing and new ARC customers, and answer marketing, documentation, and operational questions.