Sofr

What Is SOFR?

The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. It falls under the category of Financial Benchmark Rates, serving as a key indicator of the overnight funding market. SOFR reflects the actual transactional volume of overnight repurchase agreements (repos) involving U.S. Treasury securities, making it a robust and transparent rate. This measure provides crucial insight into the short-term financing costs within the U.S. financial system.

History and Origin

SOFR emerged as a primary alternative to the London Interbank Offered Rate (LIBOR), which faced scrutiny and eventual phase-out due to manipulation scandals and a decline in underlying interbank lending. In 2017, the Alternative Reference Rates Committee (ARRC), a group convened by the Federal Reserve Board and the New York Federal Reserve, identified SOFR as its recommended alternative to USD LIBOR.³¹,³⁰,²⁹ This recommendation marked a significant step in transitioning global derivatives and other financial contracts to a more robust benchmark rate. The Federal Reserve Bank of New York began publishing SOFR daily on April 3, 2018.²⁸ The transition intensified with the formal recommendation of Term SOFR by the ARRC in July 2021, a forward-looking version of SOFR aimed at accommodating certain cash products.²⁷,²⁶ The International Swaps and Derivatives Association (ISDA) also played a pivotal role by developing the 2020 IBOR Fallbacks Protocol, providing a standardized mechanism for existing derivative contracts to transition from LIBOR to SOFR.²⁵,²⁴,²³,²²

Key Takeaways

• SOFR is a volume-weighted median of overnight repurchase agreements collateralized by U.S. Treasury securities.
• It serves as the primary replacement for the U.S. dollar LIBOR in financial contracts.
• SOFR is considered a nearly risk-free rate, as it is based on actual transactions in a highly liquid market.
• The Federal Reserve Bank of New York publishes SOFR daily, along with compounded averages and an index.²¹,²⁰,¹⁹
• Its adoption has required significant operational and technological adjustments across the financial industry.

Formula and Calculation

The Secured Overnight Financing Rate is calculated as a volume-weighted median of transaction-level data from three key sources in the U.S. Treasury repurchase agreement market:

• Tri-party repo data collected from the Bank of New York Mellon.
• General Collateral Finance (GCF) Repo transaction data.
• Bilateral Treasury repo transactions cleared through the Fixed Income Clearing Corporation (FICC)'s Delivery-versus-Payment (DVP) service.¹⁸,¹⁷,¹⁶

The calculation generally involves:

1. Collecting Data: Gathering transaction data from the specified repo markets.
2. Filtering: Removing certain "specials" (repos for specific-issue collateral) that may distort general collateral rates.¹⁵
3. Volume-Weighting: Each transaction's rate is weighted by its volume.
4. Median Determination: The median rate of all filtered and volume-weighted transactions is determined to arrive at the daily SOFR.

While the daily SOFR is an overnight rate, many financial products, particularly longer-term ones, use compounded versions of SOFR. The Federal Reserve Bank of New York also publishes SOFR Averages (compounded over 30, 90, and 180 days) and a SOFR Index, which measures the cumulative effect of compounding SOFR over time.¹⁴

Interpreting the SOFR

SOFR is interpreted as a measure of the cost of borrowing cash overnight backed by the safest collateral, U.S. Treasury securities. A higher SOFR indicates that it is more expensive to borrow cash in the overnight repo market, while a lower SOFR suggests cheaper borrowing costs. Because it is collateralized by Treasuries, SOFR is considered a nearly "risk-free" rate, reflecting the base cost of funding.

Market participants use SOFR to gauge short-term money markets conditions and as a benchmark for various financial products. The daily SOFR provides a granular view, while the compounded SOFR Averages offer a smoothed perspective, which is often preferred for longer-term lending and hedging. Understanding SOFR's movements can provide insights into systemic market liquidity and the general cost of short-term funding for financial institutions.

Hypothetical Example

Imagine a corporation, "TechCorp," wants to take out a one-year floating-rate loan for $100 million from "Global Bank." Instead of referencing LIBOR, the loan agreement specifies that the interest rate will be based on the 3-month Term SOFR plus a spread of 1.50%. The interest payments are set quarterly.

Scenario:

• Loan Amount: $100,000,000
• Term: 1 year
• Interest Basis: 3-month Term SOFR + 1.50%
• Payment Frequency: Quarterly

First Quarter Calculation:
On the rate-setting date for the first quarter, the publicly available 3-month Term SOFR is 4.00%.
The interest rate for the first quarter would be:
( \text{Interest Rate} = \text{3-month Term SOFR} + \text{Spread} )
( \text{Interest Rate} = 4.00% + 1.50% = 5.50% )

The interest payment for the first quarter would be:
( \text{Quarterly Interest Payment} = \text{Loan Amount} \times \text{Interest Rate} \times (\frac{\text{Number of Days in Quarter}}{\text{Days in Year}}) )
Assuming a 90-day quarter for simplicity in a 360-day year:
( \text{Quarterly Interest Payment} = $100,000,000 \times 0.0550 \times (\frac{90}{360}) )
( \text{Quarterly Interest Payment} = $100,000,000 \times 0.0550 \times 0.25 = $1,375,000 )

This example demonstrates how SOFR, specifically Term SOFR, can be applied to determine interest payments on a floating-rate debt instrument, replacing the traditional use of LIBOR.

Practical Applications

SOFR is widely used across various segments of the financial markets, serving as a foundational interest rate benchmark. Its applications include:

• Derivatives: SOFR is the predominant reference rate for U.S. dollar-denominated interest rate swaps and other derivatives. The International Swaps and Derivatives Association (ISDA) has facilitated the transition of trillions of dollars in derivatives contracts to SOFR-based fallbacks.¹³
• Loans: Both syndicated and bilateral corporate loans, particularly floating-rate varieties, increasingly reference SOFR, including Term SOFR, as a replacement for LIBOR.¹²
• Bonds and Securitizations: New issues of floating-rate notes, commercial mortgage-backed securities (CMBS), and other asset-backed securities (ABS) are now commonly indexed to SOFR. This adoption impacts the entire bond market.
• Financial Instruments: It underpins a broad array of financial instruments, including repurchase agreements and other short-term borrowing and lending activities.
• Risk Management: Financial institutions utilize SOFR in their internal risk management frameworks for pricing, valuation, and hedging of interest rate exposures.

The transition to SOFR from LIBOR has been a massive undertaking for financial institutions, necessitating updates to systems, processes, and documentation.¹¹,¹⁰

Limitations and Criticisms

Despite its advantages, SOFR has faced certain limitations and criticisms:

• Overnight Nature: SOFR is primarily an overnight rate, reflecting very short-term borrowing costs. This contrasts with LIBOR, which offered various forward-looking tenors (e.g., 1-month, 3-month, 6-month). While Term SOFR has been developed to address this, its scope of use is generally limited to certain cash products like business loans.⁹,⁸
• Lack of Credit Sensitive Component: SOFR is a secured rate, based on transactions collateralized by U.S. Treasuries, making it nearly risk-free. LIBOR, conversely, was an unsecured rate that incorporated a bank credit risk premium. This difference means SOFR may not fully reflect the funding costs for banks during periods of financial stress, which some market participants view as a drawback.
• Volatility: Compared to LIBOR's historical stability (due to its nature as a polled rate), SOFR can exhibit higher day-to-day volatility, particularly around month-ends and quarter-ends, due to fluctuations in repurchase agreements activity and market liquidity.⁷ This volatility can present operational and pricing complexities for some financial institutions.
• Operational Challenges: The transition from LIBOR to SOFR has presented considerable operational, accounting, and technological challenges for market participants, requiring significant system upgrades and new calculation methodologies.⁶,⁵,⁴ Central banks and regulatory bodies continue to monitor the ongoing adoption and address these challenges.

SOFR vs. LIBOR

The Secured Overnight Financing Rate (SOFR) and the London Interbank Offered Rate (LIBOR) served as critical benchmark rates in financial markets, but they differ fundamentally in their underlying methodology and risk characteristics.

The fundamental distinction lies in SOFR being a secured rate based on actual, observable transactions in the repo market, making it more robust and transparent. LIBOR, conversely, was an unsecured rate based on a survey of banks' estimated borrowing costs, which led to its susceptibility to manipulation and eventual discontinuation.

FAQs

What does "secured" mean in SOFR?

"Secured" in SOFR refers to the fact that the borrowing and lending transactions underlying the rate are collateralized, primarily by U.S. Treasury securities. This collateral greatly reduces the credit risk for the lender, making SOFR a nearly risk-free rate.

Why did SOFR replace LIBOR?

SOFR replaced LIBOR primarily due to concerns about LIBOR's reliability and integrity. LIBOR was based on subjective bank submissions and had been involved in manipulation scandals. As a transaction-based rate derived from a deep and liquid market, SOFR offers greater transparency and resilience, making it a more robust benchmark rate for financial contracts.

Is SOFR a forward-looking or backward-looking rate?

The daily SOFR is a backward-looking, overnight rate, meaning it reflects the cost of borrowing for the previous day. However, to accommodate various financial products that previously used forward-looking LIBOR tenors, compounded SOFR averages are published, and a forward-looking "Term SOFR" has been developed and adopted for specific uses, such as in loans.