Understanding SOFR: The Secured Overnight Financing Rate

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Disclaimer: This blog is intended for informational purposes only and should not be considered financial advice. Consult with a financial advisor for advice tailored to your individual circumstances.

The Secured Overnight Financing Rate (SOFR) is poised to replace the London Interbank Offered Rate (LIBOR) as the global benchmark for lending rates by mid-2023. Derived from the Treasury "repo" market, SOFR represents the borrowing costs of cash collateralized by Treasury securities.



What is SOFR?

SOFR stands for the "Secured Overnight Financing Rate" and reflects the costs associated with borrowing cash collateralized by Treasury securities in the repo market. The repo market involves short-term borrowing and lending transactions secured by highly liquid securities, primarily U.S. Treasury securities.

Participants in the Repo Market

Key participants in the repo market include:

  • Banks and Financial Institutions (Primary Dealers)
  • Corporations
  • Governments (e.g., NY Fed, Central Bank, Municipalities)
  • Calculation and Publication of SOFR

Every morning, the New York Federal Reserve calculates and publishes SOFR by taking the volume-weighted median of transaction data from three repo markets:

  • Tri-party Repo Market: Involves securities dealers, cash investors, and clearing banks acting as intermediaries.
  • General Collateral Finance (GCF) Repo Market: Features collateralized repurchase agreements where the assets pledged are unspecified until the end of the trading day.
  • Bilateral Repo Market: Involves asset managers and institutional investors borrowing securities from broker-dealers and securities lenders, either bilaterally or cleared by the Delivery vs. Payment (DVP)

Service of the Fixed Income Clearing Corporation (FICC).

SOFR vs. LIBOR: Key Differences

LIBOR (London Interbank Offered Rate) has been the standard benchmark for setting lending rates globally. It reflects the rate at which banks lend to each other and has historically influenced loans, bonds, mortgages, and derivatives.

Key Differences Between SOFR and LIBOR:

  • Basis of Calculation: SOFR is fully transaction-based, reflecting actual borrowing costs in the overnight repo market, whereas LIBOR is derived from data submitted by major banks.
  • Susceptibility to Manipulation: SOFR's transaction-based nature makes it less susceptible to manipulation compared to LIBOR.
  • Rate Duration: SOFR is an overnight rate, while LIBOR includes terms ranging from overnight to twelve months.

The Transition from LIBOR to SOFR

The transition from LIBOR to SOFR was initiated following a scandal in which traders at major financial institutions manipulated LIBOR rates for profit. In response, U.K. regulators announced plans to phase out LIBOR by the end of 2021, with the Alternative Reference Rate Committee (ARRC) recommending SOFR as the replacement in mid-2017.

Despite initial plans, the transition has been gradual to minimize market volatility. The USD LIBOR is expected to cease new financial contracts by June 30, 2023, as mandated by U.S. banking regulators.

Current Progress and SOFR Rates

By April 2022, approximately 96% of recently issued loans had adopted SOFR, indicating significant progress in the transition.

Checking Current SOFR Rates

For the most up-to-date SOFR rates, refer to data published by the New York Federal Reserve, available on their website.

Conclusion

SOFR is set to become the new standard for lending rates, offering a more transparent and reliable benchmark compared to LIBOR. Investors and financial institutions should stay informed about the transition to SOFR and its implications for financial contracts and instruments.

Disclaimer: This blog provides general information about SOFR and should not be considered financial advice. For personalized financial advice, consult a professional advisor.

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