Ultimate Guide on SOFR: Definition, Rates, and Comparison with LIBOR

Introduction

SOFR, aka Secured Overnight Financing Rate, is a fully transaction-based rate that reflects the cost of borrowing cash overnight. It’s very lucrative for the regulators, less susceptible to market volatility, and secured by U.S. Treasury securities. To understand simply, SOFR is like a ‘price tag’ for how much banks pay to borrow money from each other on a very short basis (overnight), using U.S. Treasury bonds as collateral.

The UK Financial Conduct Authority (FCA) announced that they would no longer require banks to submit cost of funds quotes when calculating LIBOR (London Interbank Offered Rate) in July 2017. This decision raised the eyebrows of the majority of finance professionals about the sustainability and availability of LIBOR. In June of the same year, the Alternative Reference Rates Committee (ARRC), a private-public partnership established by the Federal Reserve Board of Governors and the Federal Reserve Bank of New York, identified the SOFR as the preferred alternative to replace USD LIBOR. By June 2023, all LIBOR rates were discontinued and their place was taken by SOFR. 

In this blog, we will understand what SOFR is, how it is calculated and the key differences between SOFR and LIBOR. 

What is Secured Overnight Financing Rate (SOFR)?

The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for derivatives and loans (denominated in US Dollars) that has replaced the London Interbank Offered Rate (LIBOR). They utilize real transaction data, making them less prone to bias and hence they are preferred by regulators. 

SOFR captures the cost of borrowing on an overnight basis and in a manner that is secure. On average, $900 billion worth of FX trades during the day are used for the quotation of SOFR. On the other hand, the USD LIBOR depends mainly on the opinions of the panel for rate calculations. Further, the most commonly traded LIBOR was the three-month USD rate and less than $1B, of transactions supported this rate, whereas SOFR is anchored on real transactions of borrowing and lending, which makes it a solid basis for market development day in and day out.

Losing sight of cash and liquidity due to volatile interest rates can be worrisome. Most of the companies have now opted for treasury management solutions that embrace automation to help close the productivity gap and focus on more profit-centric activities. 

History of the SOFR

Prior to SOFR, LIBOR was the ultimate financial rate used for loans and deals between banks and investors. LIBOR was calculated by evaluating the rates at which large banks from different nations borrowed from one another. It incorporated five world currencies – U.S Dollar (USD), Euro (EUR), British pound (GBP), Japanese yen (JPY), and Swiss franc (CHF) and consisted of seven different maturity time periods. The three-month U.S. dollar price was the most commonly utilized LIBOR rate

Following the 2008 recession, a sharp decline in economic activity was noticed. Due to the same, regulators became wary of over relying on LIBOR as LIBOR rates were largely based on global banks’ estimates and necessarily on actual transactions. The drawback of providing banks with this level of independence was exposed in 2012, when more than a dozen financial institutions were found manipulating their LIBOR rates so as to profit from trade. 

With strict banking regulations coming into being after the financial crisis, there was a drastic reduction in interbank borrowing and trading which further impacted the reliability of LIBOR. With new rules that required banks to not share any interbank data after 2021, there was an increasing demand worldwide to identify an alternative rate. In 2017, the Federal Reserve (Fed) brought together an Alternative Reference Rate Committee, who selected SOFR as the new benchmark interest rate for all USD trades. 

LIBOR vs. SOFR

LIBOR differs from SOFR as the latter is based on actual transactions within the Treasury repurchase agreement (repo) market whereas LIBOR is based on estimates. Also, SOFR doesn’t use statutory borrowing or false rates. On the contrary, it takes data from real transactions, which makes it more precise.

Here’s a simple table highlighting the key differences between LIBOR and SOFR:

Transition of LIBOR to SOFR

On Nov 30, 2020, the Fed announced LIBOR’s retirement. By the end of 2021, banks were ordered to stop using USD LIBOR as reference rates in all contracts. June 30, 2023 marked the retirement of LIBOR with the cessation of all LIBOR rates and the selection of SOFR as the new USD benchmark rate. 

Transition Challenges and Considerations

Switching to SOFR poses big challenges especially in the derivatives market, however, its impact will be felt across credit related sectors. Consumer credit, adjustable-rate mortgages (ARM), and private student loans asset-backed debt securities, including commercial paper, will also be impacted.

Another SOFR transition challenge is that many countries have identified their own alternatives to LIBOR. For example, The UK has selected Sterling Overnight Index Average (SONIA) as a rate for overnight lending for its sterling deals, The European Central Bank has selected the Euro Overnight Index Average (EONIA) as the for unsecured overnight loans. Meanwhile, the Bank of Japan has chosen the Tokyo Overnight Average Rate (TONAR) as its policy interest rate. 

Organizations that make cross-country transactions and operate in different geographies, need to carefully consider and understand benchmark interest rates from banks before taking key decisions. 

What Is the Current Secured Overnight Financing Rate?

As of April 22, 2024, the current SOFR is 5.31%.

SOFR average are compounded at 30, 90, and 180 days time period. As of 25th April 2024, SOFR average is: 

How is SOFR Calculated?

SOFR is calculated by looking at the average of all volume-weighted medians of the transactions that are involved in borrowing and use US Treasury securities as collateral. These deals are also called repo transactions by the Federal Reserve Bank of New York. It publishes SOFR at 8 a.m. EST each day.

Here’s an example of how it is calculated.

Assume there are five transactions in the Treasury repo market:

To calculate SOFR, we first need to calculate the weighted average of these interest rates, where the weight is determined by the size of each transaction.

Total transaction amount = $100 million + $150 million + $200 million + $120 million + $180 million = $750 million

Weighted Average = ((100 million * 1.5%) + (150 million * 1.7%) + (200 million * 1.6%) + (120 million * 1.8%) + (180 million * 1.9%)) / $750 million

Weighted Average = (1.5 million + 2.55 million + 3.2 million + 2.16 million + 3.42 million) / $750 million

Weighted Average = 12.83 million / $750 million

Weighted Average = 0.017107

So, the SOFR for this would be approximately 1.71%.

Conclusion

The transition to SOFR from LIBOR brought about a huge change across the global financial landscape. With SOFR being steady, based on overnight rates, it has added a greater degree of transparency and enhanced reliability. As the SOFR curve is increasingly adopted as the benchmark interest rate, globally, it has impacted many financial instruments. This is the very reason why organizations are now to be cognizant of the norms of SOFR while also updating their respective processes and systems to incorporate SOFR as the US dollar benchmark rate.

FAQs

1) What does SOFR stand for?

SOFR is an abbreviation of the Secured Overnight Financing Rate. It represents the benchmark interest rate for borrowing cash overnight with the U.S. Treasury securities as collateral. It serves as an economic yardstick when setting rates for various financial products and currency swaps.

2) What is 3-month SOFR?

3-month SOFR is a forward-looking interest rate based on the expected average Secured Overnight Financing Rate (SOFR) over the next three months. It provides a benchmark for longer-term borrowing costs in financial markets.

3) What is 30-day SOFR?

30-day SOFR is a forward-looking interest rate calculated based on the expected average Secured Overnight Financing Rate (SOFR) over the next 30 days. It provides a shorter-term benchmark for borrowing costs in financial markets over one month.

4) What are SOFR futures?

SOFR futures are financial contracts where parties agree to buy or sell SOFR at a predetermined price on a specified future date. They allow market participants to hedge against or speculate on future movements in SOFR, providing risk management tools for interest rate exposure.