SOFR: Secured Overnight Financing Rate

SOFR (Secured Overnight Financing Rate) is a benchmark interest rate for dollar-denominated derivatives and loans that reflects the cost of borrowing cash overnight collateralized by U.S. Treasury securities, providing a stable and tamper-resistant alternative to LIBOR.

Definition

The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans. It reflects the cost of borrowing cash overnight collateralized by U.S. Treasury securities. Because of its foundation in actual borrowing transactions, SOFR is seen as a more stable and tamper-resistant alternative to the London Interbank Offered Rate (LIBOR).

Historical Context

SOFR was introduced by the Federal Reserve Bank of New York as a part of its efforts to reform and stabilize the financial markets after the LIBOR scandal. LIBOR, once the predominant global benchmark, faced credibility issues due to manipulation. In response, SOFR was developed to provide a more transparent, reliable, and representative rate.

Key Characteristics

• Secured: SOFR is based on secured transactions, making it inherently lower risk compared to unsecured rates like LIBOR.
• Overnight: Reflects overnight borrowing costs.
• Treasury Collateral: The borrowing is collateralized by U.S. Treasury securities, adding a layer of security.
• Tamper-resistant: Based on actual transaction data, reducing susceptibility to manipulation.

SOFR vs. LIBOR

Differences

• Basis:
  • SOFR: Secured by U.S. Treasury securities.
  • LIBOR: Unsecured and based on estimates from banks.
• Stability:
  • SOFR: Considered more stable due to its basis in actual transactions.
  • LIBOR: Has been susceptible to manipulation and volatility.
• Calculation:
  • SOFR: Reflects an overnight rate.
  • LIBOR: Includes various terms (overnight, one month, etc.).

Special Considerations

The transition from LIBOR to SOFR involves considerable adjustments, including:

• Systems Update: Financial systems and models need updating to incorporate SOFR.
• Contract Rewriting: Contracts and financial instruments referencing LIBOR need to transition to SOFR.
• Education and Training: Market participants require education on SOFR and its implementation.

Applications of SOFR

SOFR is used in various financial products, including:

• Loans: Adjustable-rate mortgages and business loans.
• Derivatives: Interest rate swaps and futures.
• Bonds: Floating rate notes.

Example Calculations

Suppose a loan of USD 1,000,000 tied to SOFR, with SOFR set at 0.25% per annum. The overnight interest will be:

$$ \text{Interest} = 1,000,000 \times \frac{0.25}{100} \times \frac{1}{365} \approx \$6.85 $$

Related Terms

• Alternative Reference Rates (ARR): Benchmark rates other than LIBOR used in various financial instruments.
• Federal Funds Rate: The interest rate at which depository institutions trade federal funds with each other overnight, used as a monetary policy tool.

FAQs

Why was SOFR introduced?

SOFR was introduced to provide a more secure, stable, and transparent benchmark rate following the manipulation issues with LIBOR.

How is SOFR calculated?

SOFR is calculated based on actual transactions in the overnight Treasury repurchase agreement (repo) market.

Is SOFR higher than LIBOR?

Generally, SOFR tends to be lower than LIBOR due to being secured by collateral (U.S. Treasuries).

What happens to LIBOR-referenced contracts?

They need to transition to alternative reference rates like SOFR by reworking financial agreements and updating systems.

Summary

The Secured Overnight Financing Rate (SOFR) is crucial in the current financial landscape as a more stable, transparent, and tamper-resistant alternative to LIBOR. Its reliance on secured transactions and actual market data makes it a reliable benchmark for various financial instruments globally.

References

1. Federal Reserve Bank of New York. (n.d.). Secured Overnight Financing Rate Data.
2. International Financial Reporting Standards Foundation. (2021). Alternative Reference Rates.