What Is the Secured Overnight Financing Rate (SOFR)?
The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that replaced the London Interbank Offered Rate (LIBOR).
SOFR took the place of LIBOR in June 2023, offering fewer opportunities for market manipulation and current rates rather than forward-looking rates and terms.
Key Takeaways
- The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that replaced the London Interbank Offered Rate (LIBOR).
- SOFR is based on transactions in the Treasury repurchase market and is preferable to LIBOR since it is based on data from observable transactions rather than estimated future borrowing rates.
- While SOFR became the benchmark rate for dollar-denominated derivatives and loans, other countries have sought their own alternative rates, such as SONIA and EONIA.
Understanding the Secured Overnight Financing Rate (SOFR)
The SOFR is an influential interest rate banks use to price U.S. dollar-denominated derivatives and loans. The daily SOFR is based on transactions in the Treasury repurchase market, where investors offer banks overnight loans backed by their bond assets.
Benchmark rates such as the SOFR are essential in derivatives trading—particularly interest-rate swaps, which corporations and other parties use to manage interest-rate risk and to speculate on changes in borrowing costs.
Interest-rate swaps are agreements in which the parties exchange fixed-rate interest payments for floating-rate interest payments. For example, in a “vanilla” swap, one party agrees to pay a fixed interest rate, and, in exchange, the receiving party agrees to pay a floating interest rate based on the SOFR—the rate may be higher or lower than SOFR, assessed on the party’s credit rating and interest-rate conditions.
In this case, the payer benefitswhen interest rates go up because the value of the incoming SOFR-based payments is now higher, even though the cost of the fixed-rate payments to the counterparty remains the same. The inverse occurs when rates go down.
History of the SOFR
The LIBOR was previously the go-to interest rate at which investors and banks pegged their credit agreements to. Comprised of five currencies and seven maturities, the LIBOR was determined by calculating the average interest rate at which major global banks borrow from one another. The five currencies were the U.S. dollar (USD), euro (EUR), British pound (GBP), Japanese yen (JPY), and the Swiss franc (CHF). The most commonly quoted LIBOR was the three-month U.S. dollar rate, at the time referred to as the current LIBOR rate.
A Financial Crisis Solution
Following the financial crisis of 2008, regulators grew wary of overreliance on LIBOR. For one, it was based largely on estimates from global banks that were surveyed—but not necessarily on actual transactions.
The downside of giving banks that much freedom became apparent in 2012 when it was revealed that more than a dozen financial institutions fudged their data in order to reap bigger profits from LIBOR-based derivative products.
In addition, banking regulations after the financial crisis meant that there was less interbank borrowing happening, prompting some officials to express concern that the limited volume of trading activity made the LIBOR even less reliable. Eventually, the British regulator that compiled LIBOR rates said it would no longer require banks to submit interbank lending information after 2021. This update sent developed countries around the world scrambling to find an alternative reference rate that could eventually replace it.
Federal Reserve Action
In 2017, the Federal Reserve (Fed) responded by assembling the Alternative Reference Rate Committee, composed of several large banks, to select an alternative reference rate for the United States. The committee chose the Secured Overnight Financing Rate (SOFR), an overnight rate, as the new benchmark for dollar-denominated contracts.
The Federal Reserve Bank of New York began publishing the SOFR in April 2018 as part of the effort to replace LIBOR.
SOFR vs. LIBOR
Unlike the LIBOR, there’s extensive trading in the Treasury repo market—roughly $4.8 trillion in June 2023—theoretically making it a more accurate indicator of borrowing costs.
Moreover, the Secured Overnight Financing Rate (SOFR) is based on data from observable transactions rather than on estimated (or falsified) borrowing rates, as was generally the case with LIBOR.
Transitioning to the SOFR
On Nov. 30, 2020, the Federal Reserve announced the LIBOR would be phased out and eventually replaced by June 2023. In the same announcement, banks were instructed to stop writing contracts using LIBOR by the end of 2021.
The LIBOR and the Secured Overnight Financing Rate (SOFR) coexisted until June 2023, when SOFR became the standard in the U.S.
Transition Challenges
The move to the SOFR is expected to have the greatest impact on the derivatives market. However, it should also play an important role in consumer credit products—including some adjustable-rate mortgages and private student loans—as well as debt instruments such as commercial paper.
In the case of an adjustable-rate mortgage based on the SOFR, the movement of the benchmark rate determines how much borrowers will pay once the fixed interest period of their loan ends. If the SOFR is higher when the loan “resets,” homeowners will be paying a higher rate as well.
Special Considerations
Other countries have sought alternatives to the LIBOR. For instance, the United Kingdom chose the Sterling Overnight Index Average (SONIA), an overnight lending rate, as its benchmark for sterling-based contracts going forward.
The European Central Bank (ECB), on the other hand, opted to use the Euro Overnight Index Average (EONIA), which is based on unsecured overnight loans, while Japan applied its own rate, called the Tokyo overnight average rate (TONAR).
What Is the Current Secured Overnight Financing Rate?
On June 1, 2023, the SOFR was 5.08%, according to the Federal Reserve Bank of New York.
What's the Difference Between LIBOR and SOFR?
SOFR measures the broad cost of overnight cash borrowing, using Treasury securities as collateral. LIBOR was the rate banks used to borrow from each other internationally—it was sunsetted in June 2023.
Is There a 3-Month SOFR Rate?
The Federal Reserve does not publish a three-month SOFR rate, but the Chicago Mercantile Exchange publishes one-, three-, six-, and 12-month Term SOFR rates for derivatives markets.
The Bottom Line
The Secured Overnight Lending Rate (SOFR) is the benchmark for interest rates on dollar-denominated loans and derivatives. It replaced the London Intrabank Offered Rate in 2023, which was the globally accepted rate before SOFR was adopted. SOFR reflects an overnight rate, whereas LIBOR was a forward-looking rate, making SOFR much less susceptible to market fluctuations and manipulation.
