December 15, 2021

Effective December 1, 2021, the Loan Syndication and Trading Association (LSTA) has issued a revised suite of loan trading documents modified to replace LIBOR (London Interbank Offered Rate) with SOFR (Secured Overnight Financial Rate) as the metric by which “cost of carry” will be calculated for all new loan trades regardless of the interest rate or currency of the underlying loan.

The LSTA publishes the trading documents, including standard terms and conditions for the form trade confirmations, participation agreements and a purchase and sale agreement for distressed trades, that are used for more than $800 billion in loan trades annually representing most secondary trades in US dollar loans.  These trading documents set out the legal obligations of each party to a trade as well as the economic provisions for settlement, with the goal of decreasing settlement times and creating fairness between buyer and seller.

A defining feature of the LSTA pricing terms is the concept of delayed compensation of which “cost of carry” is a central facet.  Under the LSTA documents, if a trade remains open beyond a certain period of time after the trade date (T+7 for par and T+20 for distressed trades), the buyer is entitled to interest as of the last day of such period (the “Commencement Date”) provided the Buyer has met certain obligations set forth in the Standard Terms and Conditions for primary allocations, par and distressed trades, respectively.  However, offsetting the benefit of such interest, the buyer is obligated to pay the seller a fee for the buyer’s use of capital, with such fee accruing daily for each business day during the “Delay Period,” beginning on the Commencement Date and concluding one day prior to the delayed settlement date. This fee is called “Cost of Carry.” Charging the buyer Cost of Carry prevents the buyer from unjustly reaping the benefits of the economics of the loan, including accruing interest, for a period where the buyer has not yet paid for the loan. Additionally, particularly in a high-interest rate environment, charging the buyer Cost of Carry incentivizes the buyer to close the trade. Cost of Carry is generally added to the purchase price and netted off against the accrued interest which the seller will owe to the buyer.

Until now, Cost of Carry has been calculated at a rate equal to the average one-month LIBOR during the pendency of the delay period[1] in the applicable currency of the transaction for underlying loans earning the LIBOR[2]. One week and two-month USD LIBOR will cease to be published by the relevant administrator after December 31, 2021 and one, three and six month USD LIBOR will cease to be published after June 30, 2023. For several reasons, most notably that LIBOR no longer reflects actual transactions between banks and thus may not be a reliable proxy of funding costs and may be subject to manipulation.

Following the announcement by the administrator for LIBOR that all tenors of LIBOR would cease to be published in 2023, the LSTA set out to find or create a replacement rate at which to calculate Cost of Carry. As an interim step, on September 13, 2021, the LSTA revised the standard terms of the LSTA trade documents to allow for Cost of Carry to be calculated based on a number of different rates often corresponding to the interest rate of the underlying credit agreement. However, since the vast majority of all the relevant loan agreements still use LIBOR rather than an alternative rate, Cost of Carry for most trades would still be calculated using LIBOR[3], meaning that these updates to the standard terms had minimal effect.

On December 1, 2021, the LSTA took the further step of issuing revised documents to be used for all trades entered into on or after December 1, 2021 and removed the reference to LIBOR within the Cost of Carry Rate definition. Cost of Carry is now calculated on the basis of daily SOFR for the period beginning two Business Days before the Commencement Date and ending two Business Days before but not including the Delayed Settlement Date divided by the total number of days in such period, plus a spread adjustment to compensate for certain structural differences between LIBOR and SOFR equal to 11.448 basis points. Note that while all LSTA documents are now reissued dated as of December 1, 2021, the LSTA only changed the Standard Terms and Conditions for the Trade Confirm for par and distressed loans, and the Primary Allocation Confirm for use in the primary market. None of the other standard LSTA documents were affected by the above modifications.

SOFR is the rate recommended to replace U.S. dollar LIBOR for specified markets by the Alternative Reference Rate Committee (ARRC.), an advisory committee encompassing a range of market participants which was convened by the US. Federal Reserve to guide the market in the transition away from LIBOR. SOFR is based on the approximately $1 trillion of daily transactions in the overnight repurchase markets for US Treasuries. The massive size of the underlying market makes SOFR an actual transaction-based rate that better reflects current financing cost than LIBOR and is less prone to manipulation than LIBOR.

In the current low-interest rate environment, the rates for one-month USD LIBOR and average daily SOFR over a 30-day period are now about 0.10 and 0.05 respectively. Although these rates are both low by historical standards, what they reflect is meaningfully different. While SOFR is based on the actual borrowing costs for a huge volume of transactions, these transactions are all secured by U.S. Treasuries and is therefore an economically different metric than LIBOR, which represents unsecured overnight or term borrowing among banks in the Eurodollar market. To bridge this structural gap between LIBOR, which involves credit risk for interbank lending, and SOFR, which is based on transactions secured by U.S. Treasuries and so is essentially a “risk-free rate”, pursuant to the December 2021 documents, a spread adjustment equal to 11.448 basis points has been added to the Cost of Carry calculation 11.448 basis points is the ARRC-recommended spread adjustment for the replacement of one-month LIBOR.

It is important to note that for a trade entered into prior to December 1, 2021 (under the LSTA documents published on September 13, 2021 or earlier) the prior regime of LIBOR rates will continue to apply. This means that operations personnel will need to use multiple methods of calculating pricing possibly even under the same loan.

[1] The period from, and including, the date two (2) business days before the commencement date and to, but excluding, the date that is two (2) business days before the actual settlement date.

[2] Calculations of additional Cost of Carry calculations for non-LIBOR loans can be found in the Standard Terms and Conditions of the Par and Distressed Trade Confirmations published by the LSTA dated September 13, 2021.

[3] A “RFR” (Risk Free Rate) is an example of a Cost of Carry that is calculated not using the underlying interest rate of the credit agreement under the September 13, 2021 documents.