SOFR

Leveraging SOFR to Ensure a Transparent Financial Ecosystem 

A transparent global financial market is good for economies, businesses, and individuals alike. This is why benchmark rates like SOFR exist.

SOFR stands for secured overnight financing rate, which serves as a reference interest rate that helps financial experts price loans and other dollar-based financial products. It also serves as a benchmark replacement for the London Interbank Offered Rate (LIBOR), another standard rate.

This article explores SOFR and its role in ensuring an accountable financial landscape.

Guide to Secured Overnight Financing Rate (SOFR)

What SOFR Means in Finance

SOFR is a broad measure of the interest rates banks pay each other for short-term loans collateralized by United States Treasury securities. In other words, it is a benchmark rate that sets the tone for interbank financial transactions. The United States government unveiled this system in June 2023, as a replacement for LIBOR. Below, we’ll explore why this replacement was necessary.

Why SOFR Replaced LIBOR

London Interbank Offered Rate (LIBOR)

LIBOR was a popular benchmark rate based on what banks typically charged each other for short-term loans. Originating in the United Kingdom in 1986, LIBOR emerged as the standard rate for a number of financial products, including currency swaps, adjustable-rate mortgages, car loans, home loans, and student loans.

The Intercontinental Exchange (ICE) established LIBOR, structuring the rate around currencies like the US Dollar, British Pound, Euro, Swiss Franc, and Japanese Yen—as well as maturity periods ranging from overnight to one year.

ICE calculated LIBOR by averaging how much UK banks charged one another for short-term loans. This rate proved useful in many financial scenarios, although it presented several stability and transparency issues, including:

• Accuracy issues: LIBOR’s reliance on estimated data, rather than transactional data, posed accuracy and reliability issues.
• Vulnerable to manipulation: Some banks deliberately falsified interest rate estimates to attract business. This gave them an unfair advantage over other banks and financial institutions.
• Undue influence: This manipulation also meant that these banks were unfairly influencing loan costs worldwide.
• Unsecured: LIBOR didn’t have the backing of government bonds or other securities.

The above concerns made it necessary to find a benchmark replacement. 

The Alternative Reference Rates Committee (ARCC)

In 2014, the Federal Reserve Board formed the Alternative Reference Rates Committee. The main objective of this committee was to find a new benchmark rate. In 2017, ARCC officially endorsed SOFR as its preferred benchmark rate.

Consequently, ARCC, the Federal Reserve, and other parties jointly rolled out this alternative rate. Financial authorities in the United States officially sunset LIBOR in June 2023.

Secured Overnight Financing Rate (SOFR)

A distinct advantage of SOFR is that it uses observable transaction data rather than estimates. By extension, SOFR rates more accurately reflect actual overnight cash borrowing.

Moreover, SOFR is collateralized by the United States Treasury, adding a strong layer of security and functionally making SOFR a risk-free rate. For these reasons, SOFR has emerged as the gold standard for pricing financial products, including both corporate and consumer loans, as well as dollar-based derivatives.

Additional Reasons Why SOFR is Better than USD LIBOR

The following table from the Farm Credit Administration compares SOFR and USD LIBOR:

How SOFR is Calculated

To calculate SOFR, financial authorities gather data from overnight cash borrowing markets and Treasury repurchase agreements, or “repo deals.” Repo deals involve selling a treasury security with an agreement to repurchase it later at a slightly higher price. This Treasury repurchase market is much larger than the interbank loan market that LIBOR used.

The New York Fed is the entity that calculates and publishes SOFR rates. The group determines the rate in the following steps:

1. Reviewing transaction info from various markets, including: 
   • Tri-party repo data 
   • General Collateral Finance (GCF) repo transaction data
   • Treasury repo transaction data
2. Finding the volume-weighted median among these transactions. 
3. Publishing this value as the benchmark rate.

The New York Fed publishes the SOFR rate on their website around 8:00 a.m. ET every business day. 

Types of Secured Overnight Financing Rates

Daily Simple SOFR

Daily simple SOFR is calculated daily without considering the interest accrued on previous days — essentially offering a simple daily rate measure without compounding interest. Industry experts often use this type when they need a straightforward day-to-day rate.

Daily Compounded SOFR

This type is calculated daily and takes into account the interest accrued — providing a comprehensive view of the total borrowing cost over a particular interest period. Use cases for daily compounded SOFR include financial products and contracts where the interest is expected to compound daily.

CME Term SOFR

Term SOFR provides interest rates for specific borrowing durations, such as 1, 3, 6, and 12 months. Experts describe this SOFR type as a “forward-looking term rate” because:

• It incorporates market participants’ expectations about future rates.
• It provides insightful predictions of market conditions across different time frames.

Term SOFR can help design financial products that require interest rates for specified periods — including fixed-term loans, contracts, and derivatives.

SOFR Averages

SOFR averages are measured by compounding rates over consecutive 30-, 90-, and 180-day intervals. This process mirrors the accrual of interest over these defined periods. 

SOFR averages serve to provide a smoother, more stabilized representation of the financial data, allowing for a clearer understanding of the average cost or return associated with short-term borrowing or lending over specific timeframes. 

SOFR Index

The SOFR index reflects the impact of compounding SOFR over time, accounting for the average interest accrued on an investment — helping investors to mitigate risk associated with fluctuating interest rates and to project how investments will evolve over time.

What is the Current SOFR Rate?

The SOFR rate as of 24 October 2023 was 5.30%.

The table below provides other recent rates:

How LIBOR and SOFR Calculate Floating Rates

Floating rate is a type of interest rate that changes periodically according to its underlying benchmark rate — increasing or decreasing over time in response to market fluctuations. LIBOR can be used to calculate floating rates using this expression: 

LIBOR Rate + X or Spread or the Credit Risk

SOFR can also be used to calculate floating rates based on reference rates. This can be achieved by either referencing daily compounding interest during the interest period or by utilizing the published daily SOFR index values at the period’s outset and conclusion.

Practical Examples of LIBOR vs SOFR Applications

Previously, people who opted for LIBOR-based car loans were required to pay interest rates in the LIBOR + X format. They received quotes like LIBOR + 2.6%. This 2.6% would typically increase if an applicant had a low credit score or several missed payments. With SOFR, a creditor may use the daily compounded interest or the SOFR index value to calculate the interest rate on a loan. 

Managing the LIBOR-SOFR Transition

The shift from LIBOR to SOFR affected financial products tied to LIBOR. The International Swaps and Derivatives Association (ISDA) created rules or “fallback provisions” to manage this change, including how to adjust for differences between USD LIBOR and SOFR.

The ISDA also offered a protocol allowing parties to include these rules in existing contracts. Institutions in the United States used the fallback provisions to make the transition. Financial products and contracts tied to LIBOR were also moved to SOFR, using a fallback rate.

Credit Spread Adjustment

Credit spread adjustments are another tool that made the LIBOR-SOFR transition possible. These adjustments helped ensure that SOFR aligned well with LIBOR. When financial institutions made the switch, they used these adjustments to better align the secured SOFR rates with the unsecured LIBOR rates, helping to bridge the gap between the old and new systems.

The Impact of Secured Overnight Financing Rate

The move to SOFR not only impacted U.S. financial markets but also brought increased stability and transparency to the broader global financial landscape. Below are a few examples of market participants positively influenced by the shift to SOFR.

• Banks
• Securities lenders
• Broker-dealers
• Insurance companies
• Money market funds
• Asset managers
• Pension funds
• Trade associations
  

Challenges of SOFR

Although SOFR offers several benefits for financial institutions, it’s not without downsides. One major concern is that SOFR only looks at secure overnight deals and doesn’t consider credit risk, meaning the SOFR rate may drop in the event of an economic downturn. In theory, this could influence the Federal Reserve’s decisions on adjusting the federal funds rate, which could impact SOFR and other risk-free rates.

Other potential challenges with SOFR include:

• Overnight rate vs. term rates: SOFR uses an overnight rate, but the financial market is used to forward-looking rates. It may take time for financial markets to fully adjust to the new system.
• Risk-free rate vs. credit-sensitive benchmark: SOFR is a risk-free rate, but the market is used to rates that involve risks.
• Syncing loan pricing, funding, and hedging: It can be challenging to sync loan costs, their source, and risk management.
• Systems and capabilities for new products: Transitioning from LIBOR to SOFR requires the development of new systems and processes to support new products.

What are SOFR alternatives?

There are several alternatives to SOFR rates, each with its strengths and weaknesses. The following benchmarks are common in the UK, Europe, and Asia:

• Sterling Overnight Index Average (SONIA): SONIA reflects the average rate UK banks pay each other for short-term unsecured loans, taking into account actual lending and borrowing data like SOFR.
• Euro Short-term Rate (ESTR): This is an overnight rate based on the European interbank market. It replaced the Euro Overnight Index Average (EONIA).
• Hong Kong Overnight Index Average (HONIA): This is the benchmark interest rate for overnight borrowing and lending in Hong Kong.
• Japan Tokyo Overnight Average Rate (TONA): This is the risk-free unsecured interbank overnight rate for the Japanese Yen. It observes overnight deals between trading institutions.
• Ameribor: Ameribor is a benchmark interest rate that reflects the actual unsecured borrowing costs of banks and financial institutions.

Frequently Asked Questions 

Is SOFR replacing LIBOR?

In the United States, SOFR has replaced LIBOR as the standard reference rate. Other countries use alternative financial benchmarks such as SONIA or ESTER.

Is SOFR used for USD?

Financial service providers use SOFR to price USD derivatives and loans. Other currencies may use this rate in the future.

How often is SOFR updated?

The New York Fed updates and publishes the SOFR rate daily on its website.

Role of SOFR in Promoting Financial Accountability

In summary, SOFR has emerged as a superior alternative to LIBOR due to its foundation in observable data and the security of government collateral. This risk-free, reliable, and transparent benchmark is pivotal in the pricing of various financial products like car loans and derivatives.

As you explore the potential of SOFR to enhance your financial offerings, consulting with financial experts is a prudent step to ensure successful integration.

Additional Resources

Federal Reserve (The Fed)

Overnight Rate

Treasury Bills (T-Bills)

US Dollar (USD)

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