Secured Overnight Financing Rate (SOFR)

The Secured Overnight Financing Rate (SOFR) is a reference rate that serves as an alternative to the London Interbank Offered Rate (LIBOR) for U.S. dollar-denominated transactions. It was developed by the Alternative Reference Rates Committee (ARRC) in response to concerns about the reliability and robustness of LIBOR. SOFR has been more widespread after the discontinuation of LIBOR on June 30, 2023.

SOFR is based on transactions in the U.S. Treasury repurchase agreement (repo) market, where participants borrow or lend cash overnight using U.S. Treasury securities as collateral. It represents the cost of borrowing cash overnight secured by Treasury securities and is considered a more robust and transaction-based benchmark compared to LIBOR.

Who controls SOFR?

The Secured Overnight Financing Rate (SOFR) is an important part of the financial system, and it is important to know who controls this benchmark. Here’s a look at the institutions that control SOFR.

The Federal Reserve Bank of New York (FRBNY)

The Federal Reserve Bank of New York (FRBNY) oversees the Secured Overnight Financing Rate (SOFR). The FRBNY is responsible for collecting the data used to calculate SOFR from transactions in the repo market, for calculating SOFR itself, and for publishing it daily.

Alternative Reference Rates Committee (ARRC)

The Alternative Reference Rates Committee (ARRC), a private sector group sponsored by the Federal Reserve System, plays an important role in setting the specifications for SOFR, as well as advising on its long-term use in markets. The members of ARRC are representatives from various parts of the financial markets and include banks, asset managers, dealers, law firms and trade associations.

U.S. Treasury Department

The U.S. Treasury Department is also involved in setting SOFR because it helps to set monetary policy through its fiscal balance sheet. This means that when the Treasury purchases or sells securities or when it participates in repurchase agreements with other banks or investors within the repo market it can have an effect on short-term interest rates and potential how otherwise impacted by movements in SOFR .

Is SOFR a fixed or variable rate?

SOFR (Secured Overnight Financing Rate) is a variable rate. It is a benchmark interest rate that is used in financial markets to determine the cost of borrowing for short-term loans. SOFR is calculated based on overnight repurchase agreement (repo) transactions, which are collateralized loans made between financial institutions. The rate is determined by market forces and can fluctuate daily based on supply and demand dynamics in the lending market. Therefore, SOFR is considered a variable rate.

Key Features of SOFR:

1. Overnight Rate: SOFR is an overnight rate, reflecting borrowing costs for a 24-hour period. It captures the cost of short-term borrowing in the U.S. financial system.
2. Secured Rate: SOFR is a secured rate because it is based on collateralized transactions in the repo market, where U.S. Treasuries are used as collateral. This collateralization reduces credit risk and enhances the reliability of the rate.
3. Transaction-Based: SOFR is calculated based on actual transactions in the repo market. It is derived from a broad set of data, ensuring a robust and representative benchmark that is less susceptible to manipulation.
4. Volume and Liquidity: The repo market is a deep and liquid market, with significant transaction volume. This ensures that SOFR is based on a reliable and meaningful dataset.

Use and Transition to SOFR:

SOFR is gaining prominence as a reference rate across various financial products and contracts, including derivatives, loans, mortgages, and floating-rate notes. It is endorsed by regulatory bodies, including the Federal Reserve, as the preferred alternative to LIBOR.

The transition from LIBOR to SOFR is a global effort, with market participants working to adopt and adapt to the new reference rate. The discontinuation of LIBOR is scheduled on June 30, 2023, and industry initiatives are focused on ensuring a smooth transition to alternative rates such as SOFR.

Benefits of SOFR:

The Secured Overnight Financing Rate (SOFR) offers several benefits as a reference rate in financial markets. Here are some key advantages of using SOFR:

1. Robustness and Reliability: SOFR is derived from the U.S. Treasury repurchase agreement (repo) market, which is a deep and liquid market. This makes SOFR a robust and reliable benchmark, capable of providing accurate pricing information even during times of market stress or volatility.
2. Transaction-Based Nature: SOFR is based on actual transactions rather than estimations or surveys. It incorporates a wide range of overnight secured borrowing transactions, ensuring a more accurate representation of borrowing costs. This transaction-based nature enhances the credibility and reliability of SOFR as a reference rate.
3. Diverse Data Set: SOFR is calculated using a broad set of transactions in the repo market, involving numerous market participants and a variety of collateral. This diverse data set helps ensure that SOFR captures a comprehensive view of borrowing costs, making it a representative benchmark for the U.S. dollar-denominated market.
4. Regulatory Support and Endorsement: SOFR has gained strong support and endorsement from regulatory bodies such as the Federal Reserve and the Alternative Reference Rates Committee (ARRC). This backing ensures the credibility and longevity of SOFR as a reliable reference rate, promoting its widespread adoption in financial contracts and transactions.
5. Alignment with Collateralized Markets: SOFR is a secured rate that reflects borrowing costs against collateral, aligning it with the collateralized nature of many financial transactions. This makes SOFR particularly suitable for pricing and valuing secured loans, derivatives, and other collateralized instruments.
6. Reduced Manipulation Risks: SOFR’s transaction-based methodology reduces the vulnerability to manipulation that was associated with some reference rates in the past. By relying on actual transaction data, SOFR mitigates the risks of false reporting or manipulation, contributing to market integrity and enhancing confidence among market participants.
7. Global Recognition: While initially developed for the U.S. market, SOFR has gained recognition and acceptance in global financial markets. Its prominence as an alternative reference rate facilitates cross-border transactions and harmonization of practices, making it easier for international investors and borrowers to adopt SOFR in their operations.
8. Smooth Transition from LIBOR: With the discontinuation of the London Interbank Offered Rate (LIBOR) approaching, SOFR serves as a viable alternative and provides a seamless transition for market participants. By adopting SOFR, financial institutions can ensure continuity and stability in their lending, borrowing, and derivative activities, avoiding disruptions that could arise from the discontinuation of LIBOR.

Who uses SOFR?

SOFR (Secured Overnight Financing Rate) is used by a wide range of market participants, including financial institutions, corporations, investors, and individuals. Here are some key users of SOFR:

1. Financial Institutions: Banks, investment banks, and other financial institutions utilize SOFR as a reference rate for pricing and valuing various financial products. This includes loans, mortgages, derivatives, and other interest rate-sensitive instruments. Financial institutions also incorporate SOFR in their risk management and hedging strategies.
2. Corporations: Corporations, especially those with significant borrowing activities, may use SOFR as a benchmark for setting interest rates on their debt instruments. This includes corporate bonds, commercial paper, and other forms of corporate borrowing. SOFR provides a transparent and reliable reference rate for determining borrowing costs.
3. Investors: Institutional and individual investors incorporate SOFR in their investment decisions. For instance, asset managers may use SOFR as a benchmark for evaluating the performance of money market funds or fixed-income portfolios. Investors may also reference SOFR in analyzing the fair value of financial instruments or assessing the risk-return characteristics of investment opportunities.
4. Government Agencies: Government agencies, such as central banks or regulatory bodies, may refer to SOFR in their policy decisions and market operations. For example, the Federal Reserve in the United States considers SOFR when setting monetary policy and managing liquidity in financial markets.
5. Industry Associations and Standards Bodies: Industry associations and standards bodies play a crucial role in promoting the adoption and implementation of SOFR. For instance, the Alternative Reference Rates Committee (ARRC) in the U.S. provides guidance and recommendations for market participants in transitioning from LIBOR to SOFR.
6. Market Data Providers and Technology Platforms: Market data providers and technology platforms integrate SOFR into their offerings. They provide access to real-time and historical SOFR data, allowing market participants to monitor and analyze the rate’s movement and its impact on financial markets.

It is important to note that the adoption of SOFR varies across jurisdictions and market segments. While it is primarily associated with the U.S. dollar-denominated market, efforts are underway to promote the use of SOFR as a global benchmark reference rate.

Conclusion:

The introduction of SOFR addresses the need for a reliable and transparent reference rate as an alternative to LIBOR. As a secured overnight rate derived from actual transactions in the repo market, SOFR offers greater accuracy and robustness. It is poised to become the standard reference rate for U.S. dollar-denominated transactions, contributing to the stability and integrity of financial markets.