Secured Overnight Financing Rate (SOFR) Definition and History

What Is the Secured Overnight Financing Rate (SOFR)?

The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London Interbank Offered Rate (LIBOR). Interest rate swaps on more than $80 trillion in notional debt switched to the SOFR in October 2020. This transition is expected to increase long-term liquidity but also result in substantial short-term trading volatility in derivatives.

Understanding the 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 Secured Overnight Financing Rate (SOFR) is based on transactions in the Treasury repurchase market, where investors offer banks overnight loans backed by their bond assets.

Benchmark rates such as the 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 the 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 counterparty remains the same. The inverse occurs when rates go down.

History of the Secured Overnight Financing Rate (SOFR) 

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, the 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), and the most commonly quoted LIBOR is the three-month U.S. dollar rate, usually referred to as the current LIBOR rate.

Following the financial crisis of 2008, regulators grew wary of overreliance on that particular benchmark. For one, the LIBOR is based largely on estimates from 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.

In addition, banking regulations after the financial crisis meant that there was less interbank borrowing happening, prompting some officials to express concern that the limited volume of trading activity made the LIBOR even less reliable. Eventually, the British regulator that compiles LIBOR rates said it will no longer require banks to submit interbank lending information after 2021. This update sent developed countries around the world scrambling to find an alternative reference rate that could eventually replace it.

In 2017, the Federal Reserve (Fed) responded by assembling the Alternative Reference Rate Committee, comprising several large banks, to select an alternative reference rate for the United States. The committee chose the Secured Overnight Financing Rate (SOFR), an overnight rate, as the new benchmark for dollar-denominated contracts.

The Secured Overnight Financing Rate (SOFR) vs. LIBOR

Unlike the LIBOR, there’s extensive trading in the Treasury repo market—roughly 1,500 times that of interbank loans as of 2018—theoretically making it a more accurate indicator of borrowing costs.

Moreover, the Secured Overnight Financing Rate (SOFR) is based on data from observable transactions rather than on estimated borrowing rates, as is sometimes the case with LIBOR.

Transitioning to the Secured Overnight Financing Rate (SOFR)

For now, the LIBOR and the Secured Overnight Financing Rate (SOFR) will coexist. However, it’s expected that the latter will supplant the LIBOR over the next few years as the dominant benchmark for dollar-denominated derivatives and credit products.

On Nov. 30, 2020, the Federal Reserve announced that LIBOR will be phased out and eventually replaced by June 2023. In the same announcement, banks were instructed to stop writing contracts using LIBOR by the end of 2021 and all contracts using LIBOR should wrap up by June 30, 2023.

Transition Challenges

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 the LIBOR’s retirement. That includes the widely used three-month U.S. dollar LIBOR, which 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 instance, the LIBOR represents unsecured loans, while the SOFR, representing loans backed by Treasury bonds (T-bonds), is a virtually risk-free rate. In addition, the LIBOR actually has 35 different rates, whereas the SOFR currently only publishes one rate based exclusively on overnight loans.

The move to the SOFR will have the greatest impact on the derivatives market. However, it 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 the SOFR, the movement of the benchmark rate determines how much borrowers will pay once the fixed-interest period of their loan ends. If the SOFR is higher when the loan “resets,” homeowners will be paying a higher rate as well.

Special Considerations

Other countries have sought their own alternatives to the LIBOR. For instance, the United Kingdom chose the Sterling Overnight Index Average (SONIA), an overnight lending rate, as its benchmark for sterling-based contracts going forward.

The European Central Bank (ECB), on the other hand, opted to use the Euro Overnight Index Average (EONIA), which is based on unsecured overnight loans, while Japan will apply its own rate, called the Tokyo overnight average rate (TONAR).