What is Secured Overnight Financing Rate (SOFR)?
Secured overnight financing rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is expected to replace London inter-bank offered rate (LIBOR).
- Secured overnight financing rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is expected to replace London inter-bank offered rate (LIBOR).
- SOFR is based on transactions in the Treasury repurchase market and is seen as preferable to LIBOR since it is based on data from observable transactions rather than on estimated borrowing rates, as is sometimes the case with LIBOR.
- While SOFR is becoming the benchmark rate for dollar-denominated derivatives and loans, other countries have sought their own alternative rates, such as SONIA and EONIA.
Understanding Secured Overnight Financing Rate (SOFR)
The secured overnight financing rate, or SOFR, is an influential interest rate that banks use to price U.S. dollar-denominated derivatives and loans. The daily SOFR is based on transactions in the Treasury repurchase market, where investors offer banks overnight loans backed by their bond assets. The Federal Reserve Bank of New York began publishing the rate in April 2018 as part of an effort to replace LIBOR, a long-standing benchmark rate used around the world.
Benchmark rates such as SOFR are essential in the trading of derivatives—particularly interest-rate swaps, which corporations and other parties use to manage interest-rate risk and to speculate on changes in borrowing costs. Interest-rate swaps are agreements in which the parties exchange fixed-rate interest payments for floating-rate interest payments. In a “vanilla” swap, one party agrees to pay a fixed interest rate, and in exchange, the receiving party agrees to pay a floating interest rate based on SOFR (the rate may be higher or lower than SOFR, based on the party’s credit rating and interest-rate conditions). In this case, the payer benefits when interest rates go up, because the value of the incoming SOFR-based payments is now higher, even though the cost of the fixed-rate payments to the counter-party remains the same. The inverse occurs when rates go down.
Since its inception in the mid-1980s, the LIBOR has been the go-to interest rate to which investors and banks peg their credit agreements. Comprising of five currencies and seven maturities, LIBOR is determined by calculating the average interest rate at which major global banks borrow from one another. The five currencies are the U.S. dollar (USD), Euro (EUR), British pound (GBP), Japanese yen (JPY), and the Swiss franc (CHF). The most commonly quoted LIBOR is the three-month U.S. dollar rate, usually referred to as the current LIBOR rate.
However, after the financial crisis of 2008, regulators grew wary of overreliance on that particular benchmark. For one, LIBOR is based largely on estimates from the global banks who are surveyed and not necessarily on actual transactions. The downside of giving banks that latitude became apparent in 2012 when it was revealed that more than a dozen financial institutions fudged their data in order to reap bigger profits from LIBOR-based derivative products. Moreover, banking regulations after the financial crisis meant that there was less inter-bank borrowing happening. Some officials expressed concern that the limited volume of trading activity made the rate even less reliable. Furthermore, the British regulator that compiles LIBOR rates says it will no longer require banks to submit inter-bank lending information after 2021. That sent developed countries around the world scrambling to find an alternative reference rate that could eventually replace it.
In 2017, the Federal Reserve assembled the Alternative Reference Rate Committee, comprising several large banks, to select an alternative reference rate for the United States. The committee chose SOFR, an overnight rate, as the new benchmark for dollar-denominated contracts.
Unlike LIBOR, there’s extensive trading in the Treasury repo market—roughly 1,500 times that of inter-bank loans as of 2018—theoretically making it a more accurate indicator of borrowing costs. In addition, it’s based on data from observable transactions rather than on estimated borrowing rates, as is sometimes the case with LIBOR.
Other countries have sought their own alternatives to LIBOR. The United Kingdom chose Sterling Overnight Inter-bank Average rate (SONIA), an overnight lending rate, as its benchmark for sterling-based contracts going forward. The European Central Bank (ECB) opted to use Euro Overnight Index Average (EONIA), which is based on unsecured overnight loans, while Japan will be using its own rate, which is called TONAR.
The British regulator that compiles LIBOR rates says it will no longer require banks to submit interbank lending information after 2021.
Transitioning to SOFR
For now, LIBOR and SOFR will coexist. However, it’s expected that the latter will supplant LIBOR over the next few years as the dominant benchmark for dollar-denominated derivatives and credit products with the goal being to phase out of LIBOR by 2021.
Transitioning to a new benchmark rate is difficult, as there are trillions of dollars worth of LIBOR-based contracts outstanding and some of these are not set to mature until LIBORs retirement. For example, the widely used three-month U.S. dollar LIBOR has approximately $200 trillion of debt and contracts tied to it.
Repricing contracts is complex because the two interest rates have several important differences. For example, LIBOR represents unsecured loans, while SOFR, representing loans backed by Treasury bonds, is a virtually risk-free rate. In addition, LIBOR actually has 35 different rates while, as of now, SOFR only publishes one rate based exclusively on overnight loans.
While the transition to SOFR will have the greatest impact on the derivatives market, the rate will also play an important role in consumer credit products—including some adjustable-rate mortgages and private student loans—as well as debt instruments such as commercial paper. In the case of an adjustable-rate mortgage based on SOFR, the movement of the benchmark rate determines how much borrowers will pay once the fixed-interest period of their loan ends. If SOFR is higher when the loan “resets,” homeowners will be paying a higher rate as well.