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What Is Secured Overnight Financing Rate (SOFR)?
A standard interest rate for dollar-denominated derivatives and loans which will be replacing the London interbank offered rate (LIBOR), is called the secured overnight financing rate (SOFR).
In October 2020 the interest rate substitutes on more than $80 trillion in notional debt changed to the SOFR.
This change will result in increasing long-term liquidity but also result in substantial short-term trading volatility in derivatives.
Understanding the SOFR
An interest rate that the banks use to price U.S. dollar-denominated derivatives and loans is the secured overnight financing rate or SOFR.
The everyday secured overnight financing rate (SOFR) depends on transactions in the Treasury repurchase market, where investors offer banks overnight loans supported by their bond assets.
In the trading of derivatives especially interest rate swaps, benchmark rates such as the SOFR are required which is used by corporations and other parties to manage interest-rate risk and to speculate on changes in borrowing costs.
Agreements in which the parties exchange fixed-rate interest payments for floating-rate interest payments are called Interest-rate swaps.
When 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 then it is a “vanilla” swap, where depending on the party’s credit rating and interest-rate conditions the rate may be higher or lower than SOFR.
The payer benefits when interest rates go up in such cases, because now the value of the incoming SOFR-based payments is higher, even if the cost of the fixed-rate payments to the counterparty remains the same.
The contrary happens when rates go down.
In April 2018 as part of an effort to replace LIBOR, which has been a long-standing benchmark rate used around the world the Federal Reserve Bank of New York began publishing the secured overnight financing rate (SOFR).
History of the Secured Overnight Financing Rate
The LIBOR has been the go-to interest rate since it got established in the mid-1980s, to which investors and banks pin their credit agreements.
The LIBOR comprises five currencies and seven maturities, and it is determined by calculating the average interest rate at which major global banks borrow from one another.
The U.S. dollar (USD), euro (EUR), British pound (GBP), Japanese yen (JPY), and the Swiss franc (CHF) are the five currencies that the LIBOR incorporates, and the three-month U.S. dollar rate is the most commonly quoted LIBOR, it is also mentioned as the current LIBOR rate.
After the financial crisis of 2008, regulators grew cautious of too much dependence on that particular benchmark.
The LIBOR is leaning mainly on estimates from global banks, that are surveyed and not necessarily on actual transactions.
In 2012, the downside of giving banks that freedom became evident when it became apparent that more than a dozen financial institutions evaded their data in order to reap bigger profits from LIBOR-based derivative products.
In addition, after the financial crisis, the banking regulations meant that there was less interbank borrowing happening, which led to some officials being concerned about the limited volume of trading activity making the LIBOR even less reliable.
In due course, the British regulator that compiles LIBOR rates said, it will no longer require banks to submit interbank lending information after 2021.
This update sent developed countries around the world running around to find an alternative reference rate that could eventually replace LIBOR.
The Federal Reserve (Fed) responded in 2017 by assembling the Alternative Reference Rate Committee, including several large banks, to select an alternative reference rate for the United States.
The secured overnight financing rate (SOFR), an overnight rate, was chosen by the committee as the new benchmark for dollar-denominated contracts.
SOFR vs LIBOR
In the Secured Overnight Financing Rate (SOFR) there’s extensive trading in the Treasury repo market, if compared to interbank loans as of 2018 it is almost 1,500 times, theoretically making it a more accurate indicator of borrowing costs than the LIBOR.
LIBOR sometimes was based on estimated borrowing rates but the secured overnight financing rate (SOFR) is based on data from observable transactions.
Since the two interest rates would have several important differences repricing the contracts would be complicated.
For example, LIBOR represents an unsecured loan whereas the SOFR represents loans backed by Treasury bonds, which is a virtually risk-free rate.
While the LIBOR has 35 different rates, currently the SOFR only publishes one rate based exclusively on overnight loans.
Transitioning to the SOFR
As of now, both the LIBOR and the secured overnight financing rate (SOFR) will coexist.
However, it’s expected that SOFR will replace the LIBOR as the dominant benchmark for dollar-denominated derivatives and credit products over the next few years.
The Federal Reserve announced on November 30, 2020, that LIBOR will be phased out and eventually replaced by June 2023.
In the same announcement, banks were informed to stop writing contracts using LIBOR by the end of 2021, and by June 30, 2023, all contracts using LIBOR should wrap up.
Transition Challenges
It would be difficult to shift to a new benchmark rate because there are trillions of dollars worth of LIBOR-based contracts outstanding and few of these contracts will not mature until the LIBOR’s retirement.
This is inclusive of the widely used three-month U.S. dollar LIBOR, which has close to $200 trillion of debt and contracts tied to it.
The greatest impact on the derivatives market would be the move to the SOFR.
Similarly, it will also play an important role in consumer credit products—including some adjustable-rate mortgages and private student loans, and debt instruments such as commercial paper.
Conclusion
SOFR is a standard interest rate for dollar-denominated derivatives and loans that is replacing the London interbank offered rate (LIBOR).
SOFR is formed on transactions in the Treasury repurchase market and since it is based on data from observable transactions rather than on estimated borrowing rates it is considered better than LIBOR.
While the standard rate for dollar-denominated derivatives and loans is SOFR, other countries are looking at their own alternative rates, such SONIA and EONIA
