SOFR Definition, Calculation, Alternatives

what is sofr rate

The five currencies were the U.S. dollar (USD), euro (EUR), British pound (GBP), Japanese yen (JPY), and the Swiss franc (CHF). The most commonly quoted LIBOR was the three-month U.S. dollar rate, at the time referred to as the current LIBOR rate. 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.

The daily SOFR is based on transactions in the Treasury repurchase market, where investors offer banks overnight loans backed by their bond assets. 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. 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. In 2017, the Federal Reserve (Fed) responded by assembling the Alternative Reference Rate Committee, composed of several large banks, to select an alternative reference rate for the United States.

The 2008 financial crisis underscored the need for a more reliable benchmark than LIBOR, which was vulnerable to manipulation. Treasury repo market, emerged as a sturdy alternative, signifying a move towards more transparent, market-based benchmarks. The Secured Overnight Financing Rate (SOFR) stands as a crucial benchmark in financial markets, representing the cost of borrowing cash overnight, collateralized by Treasury securities. Its advent marks a shift from legacy benchmarks like LIBOR to a more transparent, transaction-based model, enhancing its reliability in financial operations.

what is sofr rate

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. A transparent global financial market is good for economies, businesses, and individuals alike. “SOFR provides a robust and transparent method for determining a common benchmark rate based on observed, cleared transactions in the marketplace,” says Sam Weller, Senior Vice President and Director of Capital Markets at Bryn Mawr Trust. SOFR measures the broad cost of overnight cash borrowing, using Treasury securities as collateral.

London Interbank Offered Rate (LIBOR)

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. SOFR is much less likely to be manipulated as the Treasury repo market is one of the most liquid markets in the world, which means there’s much more real transaction data to rely on, rather than self-reported hypothetical rates. 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. Unlike the LIBOR, there’s extensive trading in the Treasury repo market—roughly $4.8 trillion in June 2023—theoretically making it a more accurate indicator of borrowing costs.

The rate is published by the New York Federal Reserve to serve as a rate upon which other debt transactions can be benchmarked. It was conceived after LIBOR, a previously used benchmark rate, suffered a price manipulation scandal in no small part due to its survey based data collection method. SOFR is a volume-weighted median rate, calculated from a variety of repo transactions. Repos, or repurchase agreements, involve the sale and later repurchase of securities. Treasury securities, minimizes risk and differentiates SOFR from unsecured rates like LIBOR.

Credit spread adjustments are another tool that made the LIBOR-SOFR transition possible. 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 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.

And “this self-reported Libor rate may not accurately represent the true cost of borrowing,” notes Weller. SOFR comprises the weighted averages of the rates charged in these repo transactions. Every morning, the New York Federal Reserve Bank publishes the SOFR rate it has calculated for repo transactions on the previous business day. Eventually, the British regulator that compiled LIBOR rates said it would 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.

Why Did SOFR Replace Libor?

SOFR’s calculation uses data from a broad spectrum of repo transactions, ensuring a comprehensive market representation. This variety in data sources contributes to SOFR’s stability and reliability, making it a crucial tool for financial decision-making and policy development. 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.

  1. In 2014, the Federal Reserve Board formed the Alternative Reference Rates Committee.
  2. The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
  3. LIBOR was a popular benchmark rate based on what banks typically charged each other for short-term loans.

These repo agreements allow banks to make overnight loans to meet liquidity and reserve requirements, using Treasurys as collateral. Libor was based on the rates that financial institutions said they would offer each other for short-term loans. But SOFR takes into account actual lending transactions between institutions, making it more reliable than Libor, which Weller says was subject to insider manipulation. The SOFR is an influential interest rate banks use to price U.S. dollar-denominated derivatives and loans.

Datalign Advisory

Secured Overnight Financing Rate is at 5.31%, compared to 5.31% the previous market day and 4.55% last year. Since 2019, billions of dollars in floating-rate notes tied to SOFR have been issued in the United States, according to Ajay Patel, the Thomos S. Goho Chair in Finance at the School of Business at Wake Forest University. 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. 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.

Historical Data

Its role in providing stability and transparency is growing, poised to become a foundational element in financial markets and shaping a more resilient and transparent financial future. 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. According to Patel, few consumers should notice any impact during the shift from Libor to SOFR.

Get Forbes Advisor’s expert insights on investing in a variety of financial instruments, from stocks and bonds to cryptocurrencies and more. The Secured Overnight Financing Rate (SOFR) is Libor’s replacement in the United States. Here’s what you need to know about SOFR, how it differs from Libor and how you might be impacted by the change.


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