The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate based on US dollar collateralized loan transactions in the repo market. This rate is used as a benchmark for loans and financial derivatives, and was introduced in 2018 by the US Federal Reserve as an alternative to Libor (London Interbank Offered Rate), a benchmark rate that has been phased out due to its manipulation and unreliability.
What is the Secured Overnight Financing Rate?
SOFR measures the cost of short-term borrowing on a secured basis, i.e. loans are backed by U.S. Treasury securities as collateral. This distinguishes it from Libor, which was an unsecured rate and depended on bank estimates rather than actual transactions. SOFR is therefore considered more reliable and transparent, as it is based on a large volume of daily transactions, representing around $1,000 billion on the repo market.
The SOFR rate is published daily by the New York Federal Reserve, reflecting the weighted average of transactions carried out on the repo market for the previous day. Unlike Libor, which included several maturities (from one day to one year), SOFR is an “overnight” rate, i.e. it is based on very short-term loans, generally overnight.
Why was SOFR introduced?
The Secured Overnight Financing Rate was introduced to replace Libor, which had been used as a benchmark in trillions of dollars of financial contracts worldwide, but had proved problematic. Libor was based on banks’ statements of the rates at which they lent to each other, which allowed for some manipulation and a lack of real underlying transactions. After several scandals and insufficient reforms, global regulators decided to look for more reliable alternatives, such as SOFR.
SOFR benefits
- Transparency: Unlike Libor, SOFR is based on actual transactions, making the rate more transparent and more representative of market conditions.
- Security: Because it’s a guaranteed rate, loans backed by U.S. Treasury securities are considered to have low counterparty risk, which reinforces market stability.
- High volume: SOFR is based on a high volume of transactions, making it less prone to manipulation or volatility than Libor, which could be based on a limited number of transactions.
Use of SOFR in financial products
SOFR quickly became a benchmark rate for a variety of financial products, including :
- Variable-rate loans: Secured Overnight Financing is used in variable-rate loans to determine interest payments, particularly in the mortgage and corporate loan markets.
- Derivatives: Many derivative contracts, such as interest rate swaps, have adopted SOFR as their reference rate, gradually replacing Libor.
- Bonds and debt securities: Some floating-rate bonds and other debt instruments have also begun to use SOFR.
SOFR challenges
Although SOFR has several advantages, there are challenges in its implementation:
- Lack of forward rates: Unlike Libor, which offered rates at different maturities (such as 3 months or 6 months), SOFR is an overnight rate. This has necessitated the development of solutions to generate SOFR-based forward rates for certain longer-term financial products.
- Short-term volatility: SOFR can be more volatile in the very short term, particularly at the end of the month or the end of the year, when demand for repos increases. However, these fluctuations are mitigated when looking at multi-day averages.
Transition from Libor to SOFR
The switch from Libor to SOFR is a major process affecting trillions of dollars of financial contracts. In the United States, the deadline for abandoning Libor is 2023, after which new financial contracts must use replacement rates such as SOFR. Many existing Libor-indexed contracts also need to be revised to incorporate SOFR transition clauses.
