Term sofr

What Is SOFR?

The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. It serves as a key benchmark interest rate for dollar-denominated financial products, including derivatives and floating rate loans. SOFR falls under the broader category of financial benchmarks and interest rates, playing a crucial role in global financial markets. It is considered a nearly risk-free rate because it is based on actual, observable transactions in the highly liquid repurchase agreements (repo) market, where cash is borrowed and lent overnight against high-quality collateral like Treasury securities.

History and Origin

The Secured Overnight Financing Rate (SOFR) emerged as the primary successor to the scandal-ridden London Interbank Offered Rate (LIBOR). For decades, LIBOR was a dominant benchmark, underpinning trillions of dollars in financial contracts globally. However, its integrity was severely undermined by revelations of manipulation, where banks colluded to falsely report their borrowing costs for profit and to project financial soundness during the 2008 financial crisis. Investigations uncovered widespread misconduct, leading to billions in fines and a loss of trust in the benchmark.¹⁴

In response to these issues, global regulators initiated efforts to transition away from LIBOR to more robust, transaction-based alternative reference rates. In the United States, the Federal Reserve convened the Alternative Reference Rates Committee (ARRC) in 2014. The ARRC, a group of private-sector participants and official-sector entities, was tasked with identifying a suitable alternative.¹³ After extensive research and public consultation, the ARRC identified SOFR as the preferred alternative reference rate for U.S. dollar markets due to its transparency, robustness, and basis in a deep, active market. The Federal Reserve Bank of New York began publishing SOFR daily on April 3, 2018.¹² The transition culminated with the cessation of most U.S. dollar LIBOR settings after June 30, 2023, with the Federal Reserve Board adopting a final rule to facilitate the replacement of LIBOR with SOFR in certain contracts.¹¹

Key Takeaways

• SOFR is a U.S. dollar benchmark interest rate based on overnight repurchase agreements collateralized by Treasury securities.
• It replaced LIBOR as the primary reference rate for many financial contracts due to its transaction-based nature and reduced susceptibility to manipulation.
• SOFR is considered a nearly risk-free rate because it reflects secured overnight lending.
• The Federal Reserve Bank of New York publishes SOFR daily.
• While primarily an overnight rate, variations like Term SOFR and SOFR averages have been developed to meet market needs for forward-looking and longer-term rates.

Interpreting the SOFR

SOFR is an overnight rate, meaning it reflects the cost of borrowing cash for a single business day. Its value is determined by the volume-weighted median of transactions in the U.S. Treasury repurchase agreement market. A higher SOFR indicates an increased cost of overnight lending using Treasury securities as collateral, which can reflect tighter liquidity conditions in the money markets. Conversely, a lower SOFR suggests more ample liquidity.

Unlike LIBOR, which was a forward-looking rate based on unsecured interbank lending, SOFR is a backward-looking, secured rate. This difference fundamentally changes how market participants interpret and use the rate. For contracts requiring a term rate (e.g., three-month or six-month), daily SOFR rates are compounded over the period or SOFR averages are used. The rate's transparency and reliance on observable transactions make it a more reliable indicator of the true cost of funding within secured debt markets. Investors and financial institutions closely monitor SOFR as it influences pricing across a wide array of financial instruments.

Hypothetical Example

Consider a hypothetical corporation, Acme Corp., that needs to borrow funds using a floating rate loan for a new project. Instead of a LIBOR-based loan, their loan is now indexed to SOFR.

Suppose Acme Corp. secures a $10 million loan with an interest rate set at SOFR + 1.50%. The loan's interest is reset monthly based on the compounded SOFR over the preceding month.

• Month 1: The average daily SOFR for the previous month compounded in arrears is 5.00%.

  • Acme Corp.'s interest rate for Month 1 = 5.00% (SOFR) + 1.50% (Spread) = 6.50%.
  • Monthly interest payment = $($10,000,000 \times 0.0650) / 12 = $54,166.67$.

• Month 2: Due to shifts in the overnight lending market, the average daily SOFR for the subsequent month compounded in arrears is 5.25%.

  • Acme Corp.'s interest rate for Month 2 = 5.25% (SOFR) + 1.50% (Spread) = 6.75%.
  • Monthly interest payment = $($10,000,000 \times 0.0675) / 12 = $56,250.00$.

This example illustrates how the SOFR-indexed loan's interest payments fluctuate monthly based on changes in the underlying secured overnight financing rate, directly impacting the borrower's costs.

Practical Applications

SOFR is widely used across various segments of the financial system. It serves as the primary benchmark for pricing new U.S. dollar-denominated derivatives, including interest rate swaps and futures contracts. In the cash market, SOFR is used for corporate and syndicated loans, securitizations, and floating-rate notes. Its robust nature, backed by large volumes of daily transactions, makes it a reliable reference.¹⁰ The rate is administered by the Federal Reserve Bank of New York and is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities.⁸, ⁹

Beyond direct financial products, SOFR is also critical for risk management, valuation, and accounting processes. Financial institutions use SOFR to model their exposure to interest rate risk and manage their balance sheets. The shift to SOFR has necessitated significant changes in banking systems and market conventions, with regulators encouraging the adoption of SOFR-based instruments. The Alternative Reference Rates Committee (ARRC) played a pivotal role in guiding this transition, providing best practices and recommended fallback language for contracts.⁷ The widespread adoption of SOFR has been crucial for maintaining financial stability post-LIBOR.

Limitations and Criticisms

While SOFR offers significant advantages over LIBOR, particularly in its robustness and transaction-based nature, it also has certain limitations. One primary criticism is its overnight, backward-looking nature. Unlike LIBOR, which provided forward-looking term rates (e.g., 3-month or 6-month), the base SOFR rate only reflects past overnight transactions. This can make it challenging for some financial products, particularly longer-term loans, to determine interest payments in advance, leading to the development of compounded SOFR in arrears or Term SOFR.⁵, ⁶

Another limitation highlighted by some market participants is SOFR's lack of a credit-sensitive component. LIBOR included an element of bank credit risk, reflecting the unsecured nature of interbank borrowing. SOFR, being a secured, virtually risk-free rate, does not inherently include this credit spread. This difference can lead to basis risk for instruments that previously factored in credit risk, especially during periods of financial stress when bank funding costs diverge from secured rates.⁴ Although Term SOFR aims to provide a forward-looking measure, its use is generally recommended to be limited to end-user facing derivatives that hedge cash products, to avoid undermining the liquidity of the underlying SOFR derivatives markets.², ³

SOFR vs. LIBOR

The fundamental difference between SOFR and LIBOR lies in their underlying methodology and the type of risk they represent.

The transition from LIBOR to SOFR primarily addressed the need for a more robust and transparent benchmark, reducing the potential for manipulation and increasing market integrity. While SOFR's "risk-free" nature means it behaves differently from the credit-sensitive LIBOR, its adoption marks a significant step towards more reliable financial benchmarks.

FAQs

What is the main purpose of SOFR?

The main purpose of SOFR is to serve as a robust and transparent benchmark interest rate for U.S. dollar-denominated financial products, replacing the less reliable LIBOR. It reflects the cost of borrowing cash overnight collateralized by U.S. Treasury securities, making it a nearly risk-free rate.

How is SOFR calculated?

SOFR is calculated as a volume-weighted median of transactions in the U.S. Treasury repurchase agreement market. This includes tri-party repo data, General Collateral Finance (GCF) Repo transactions, and bilateral Treasury repo transactions cleared through FICC's DVP service. The Federal Reserve Bank of New York collects and publishes this data daily.¹

Is SOFR a forward-looking rate?

The base SOFR is an overnight, backward-looking rate, meaning it reflects past transactions. However, to meet market needs for planning and longer-term contracts, variations like "compounded SOFR in arrears" (which compounds daily SOFR rates over a period) and "Term SOFR" (a forward-looking rate derived from SOFR derivatives markets) have been developed.

Why did SOFR replace LIBOR?

SOFR replaced LIBOR primarily because LIBOR was found to be susceptible to manipulation, as it relied on subjective estimates from banks rather than actual, observable transactions. SOFR, being based on real market transactions in the deep Treasury repo market, offers greater transparency and reliability, aligning with global efforts to create more robust financial benchmarks.