What is the Secured Overnight Financing Rate (SOFR) and How Does it Work?

On June 30th 2023, the London Interbank Offered Rate (LIBOR) panel ceased operations, and the LIBOR rate was officially retired.^[1] The Secured Overnight Financing Rate (SOFR) is now the benchmark interest rate that measures the cost of borrowing cash overnight.

Since SOFR is based on data from actual transactions rather than estimated future borrowing rates (as LIBOR was), SOFR is a preferred alternative that provides a more accurate representation of overnight borrowing costs.^[2]

In this article, we’ll be explaining the intricacies of SOFR: How it is calculated, the benefits it provides over LIBOR, the impact it has on financial markets, and the challenges that lenders face when referencing SOFR.

Key Takeaways

• SOFR is the benchmark interest rate calculated by the Federal Reserve of New York, and is calculated using transactions in a trio of esoteric markets which the Fed monitors
• SOFR impacts the broader financial market in a variety of ways, most notably by providing a reference rate for lending products
• As SOFR is calculated daily, lenders face challenges when attempting to price their products in relation to SOFR, which can change drastically with little notice

How is SOFR Calculated?

SOFR is calculated by the New York Fed, which computes the volume-weighted median (50th percentile) of transactions in three markets for repurchase (repo) agreements. The three markets are: tri-party repo transactions, General Collateral Finance (GCF) Repo transaction data, and bilateral Treasury repo transactions cleared through the Fixed Income Clearing Corporation (FICC).^[3]

SOFR’s fully transaction-based rate makes it less susceptible to market manipulation than LIBOR, which primarily relied on expert judgment from the LIBOR panel's submissions to calculate the rate.^[4] The LIBOR scandal of 2012–where leading financial institutions were found to have been colluding for years to manipulate the LIBOR rate–underscored the need to transition away from a benchmark rate based on expert suggestions.

SOFR is the solution to the corruption concern that emerged in the wake of the LIBOR scandal.

How Does the Secured Overnight Financing Rate Impact the Overall Financial Market?

As SOFR determines the interest rates that borrowers will pay, it can significantly impact the overall financial market by influencing borrowing costs and lending decisions for numerous financial transactions, such as loans, derivatives and other financial contracts.^[5] SOFR is particularly significant in the traditional lending and private credit markets, as lenders rely on SOFR as a reference rate for the financial products they offer.^[6]

SOFR also plays a role in shaping the volatility and liquidity in financial markets. By offering a median reference rate as a benchmark, SOFR smoothes out the idiosyncratic, day-to-day fluctuations in market rates. The liquidity in the market is also dictated by SOFR, which moves closely with other repo rates and is found to lie generally midway between them, suggesting that it offers a reliable measure of liquidity in the financial market.^[7]

As we mentioned previously, SOFR contributes to transparency and reduces the risk of market manipulation. Unlike LIBOR, SOFR ensures that lenders can access current rates based on observable transactions, rather than estimated future borrowing rates, promoting fairness, accuracy, and stability in interest rate calculations and lending practices.^[8]

What are the Disadvantages of Using SOFR?

While SOFR offers the benefits of increased transparency and data-driven benchmarking (as opposed to estimates from the LIBOR council), there are disadvantages to using SOFR that investors should be aware of.

As SOFR is an overnight rate, it is calculated daily. Therefore, SOFR typically displays more volatility than LIBOR, which is a challenge for institutions looking to manage their financing operations, as the unpredictability of SOFR leaves little notice time before payments are due.^[9]

Another drawback of using SOFR lies in the fact that it is collateralized by U.S. Treasuries, which implies that SOFR is considered a risk-free rate. This means there is no credit premium built in, so the rate is misaligned with lender funding costs. This could pose challenges for risk management, as lenders must introduce their own credit premium into their financing calculations.^[10]

While SOFR is definitely not a panacea, it does provide significant benefits over LIBOR, as illustrated by the aforementioned LIBOR scandal. Most investors appreciate the transparency of a benchmark rate based on observable financial data, as opposed to one that is based on the suggestions of a council of financial institutions.

In Conclusion

SOFR plays an instrumental role in assessing the cost of borrowing cash overnight, determining volatility, and affirming liquidity in the financial market. Investors looking to lend capital must consider the SOFR rate as they apply an interest rate to their loan products.

While SOFR offers distinct advantages over LIBOR–namely, transparency and increased trust–the daily fluctuations pose challenges for investors looking to establish interest rates on their loan products. That said, the elimination of a council of experts may have the effect of removing the threat of collusion, which may have taken place over many years leading up to the LIBOR scandal of 2012.