On March 29, 2021, the US Alternative Reference Rates Committee (ARRC) issued a white paper (White Paper) proposing a 30-day average of the secured overnight financing rate (SOFR), with a monthly reset, in advance of the related interest accrual period for use in certain asset-backed securities (ABS) products, including non-CLO ABS and mortgage-backed securities and commercial mortgage-backed securities.
While noting that some market participants had expressed interest in an in arrears rate method (on which the ARRC continues to work), the in advance rate was designed and recommended by the ARRC’s Securitization Working Group (SWG). SWG members—including representatives of issuers, underwriters, arrangers, trustees, services, calculation agents, note administrators, trust administrators and investors—participated in a months-long process of sharing insights and perspectives on current ABS market operations, market participant preferences and market trends before reaching a consensus on this option for the use of SOFR in securitized products.
In addition, to the extent possible, approaches for using SOFR in new ABS products were developed by the SWG giving due consideration to the benefit of aligning the recommendations with existing practices. SWG members viewed having a limited number of market standards for using SOFR to be a necessary step for adoption. By looking to existing, thoroughly vetted practices for using SOFR in ABS, the SWG seeks to minimize confusion and complexity and maintain consistency within the market, thereby facilitating its adoption by market participants in ABS products. Also, the ABS market has begun to show nascent signs of accepting a SOFR-based rate, with recent issuances by Freddie Mac of ABS using 30-day average SOFR set in advance.
While some investors may prefer the interest rate to reset at the end of an interest period in order to align more with the interest rate environment that existed during the actual interest accrual period, SWG members noted that doing so presents significant operational challenges for market participants. Knowing the interest rate in advance of the interest accrual period is an important aspect of a stable and liquid market because it allows trades in ABS to occur without adjustment during the month.
The White Paper concludes by noting that the widespread adoption of average SOFR in ABS transactions will help stabilize the market during the London Interbank Offered Rate (LIBOR) cessation and reduce systemic risk. The in advance model described in the White Paper is not a binding directive nor exhaustive of all other acceptable possibilities but a consensus-based example of how a successful SOFR-based ABS product could be created using average SOFR, with interest rates determined prior to the commencement of the interest accrual period.