A new interest rate is set to replace the old London Interbank Offered Rate (LIBOR) – the Secured Overnight Financing Rate (SOFR). As the financial world moves from LIBOR to SOFR, it’s key for professionals to get to know this new benchmark. This guide will cover SOFR’s history and how it differs from LIBOR. It aims to give you the knowledge you need for this big change in finance.
Key Takeaways
- SOFR is a fully transaction-based rate derived from the Treasury repo market, making it more robust and less susceptible to manipulation compared to LIBOR.
- The transition from LIBOR to SOFR, set to be completed by June 2023, represents a significant shift in the financial industry.
- SOFR is anticipated to have daily trading volumes in the U.S. money markets ranging from $132 million for 3-month A2/P2 nonfinancial CP to $754 billion for the Secured Overnight Financing Rate (SOFR)1.
- SOFR is expected to replace LIBOR by mid-2023 and is less susceptible to market manipulation2.
- More than $200 trillion of financial contracts and securities are tied to USD LIBOR, highlighting the importance of the transition to SOFR3.
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What is SOFR?
SOFR stands for the Secured Overnight Financing Rate. It’s a key interest rate that shows how much it costs to borrow money overnight, backed by U.S. Treasury securities4. It was created to replace LIBOR, an old interest rate benchmark that faced manipulation issues and had less liquidity.
Definition and History of SOFR
The Alternative Reference Rates Committee (ARRC) developed SOFR. This group was a mix of private and public sectors, led by the Federal Reserve4. SOFR is tied to real transactions in the Treasury repo market, which was worth about $4.8 trillion in June 20234. By June 2023, SOFR officially replaced LIBOR4, and its initial rate was 5.08% as reported by the Federal Reserve Bank of New York4.
SOFR vs. LIBOR: Key Differences
SOFR and LIBOR are different in how they are calculated. SOFR comes from real transactions, whereas LIBOR was based on banks’ guesses of their borrowing costs4. Also, SOFR is an overnight rate, while LIBOR had rates for different time periods from overnight to a year4. Plus, SOFR is clearer and harder to manipulate than LIBOR.
| Metric | SOFR | LIBOR |
|---|---|---|
| Underlying Market | Treasury Repo Market | Panel Bank Estimates |
| Tenors | Overnight | Overnight to 12 Months |
| Transparency | High | Low |
| Susceptibility to Manipulation | Low | High |
The Chicago Mercantile Exchange (CME) also offers one-, three-, six-, and 12-month Term SOFR rates for derivatives markets4.
“SOFR is a more robust and transparent interest rate benchmark that is less susceptible to manipulation compared to LIBOR.”
How is SOFR Calculated?
SOFR, or the Secured Overnight Financing Rate, is figured out by the New York Federal Reserve. They use the volume-weighted median of transactions from three main repo markets. These markets are the tri-party repo, the General Collateral Finance (GCF) repo, and the bilateral Treasury repo cleared through the Fixed Income Clearing Corporation’s Delivery vs. Payment Service5.
These repo markets are all about borrowing and lending cash, but with U.S. Treasury securities as collateral.
The average daily volume of these transactions in 2020 was almost $1 trillion5. About $900 billion of these daily transactions helped calculate SOFR6. This is much more than the less than $1 billion needed for the three-month USD LIBOR calculation each day6.
Many things can change the supply and demand in the Treasury repo market. This affects the SOFR rate. For example, the Federal Funds target rate sets a floor for SOFR6. Also, bank balance sheets, money market fund sensitivity, and government MMF balances play a role6. During market stress, the demand for Treasury repo collateral goes up, making SOFR rates drop.
Money market funds (MMFs) are a big part of the repo market for SOFR6. Their reaction to Treasury Bill issuance and their balance sheet levels can greatly affect the SOFR rate.
SOFR Conventions
The financial world is moving from LIBOR to the Secured Overnight Financing Rate (SOFR). Various conventions have been created to make this change smooth. They help financial experts and keep the market consistent7.
Daily Simple SOFR
Daily Simple SOFR is a daily average of SOFR without compounding. It’s easy to understand and shows SOFR over time8.
SOFR Compounded in Arrears
SOFR Compounded in Arrears, or “SOFR-compound,” adds up daily SOFR rates during the period. It’s the most active type of SOFR and used in ISDA’s LIBOR fallback for derivatives8.
NY Fed Average SOFR
The NY Fed Average SOFR averages the previous period’s SOFR. It’s known at the start of a period. This method has its pros and cons7.
CME Term SOFR
CME Term SOFR is a forward-looking rate, using futures and derivatives for a specific period. It’s similar to LIBOR, setting at the period’s start with future market data7. It’s a top choice for the ARRC’s LIBOR fallback for loans, liked for its ease of use9.
“The recommended conventions for SOFR aim to provide a seamless transition from LIBOR to SOFR for financial professionals.”
Transition from LIBOR to SOFR
The shift from the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR) was prompted by worries about LIBOR’s trustworthiness and possible manipulation10. In 2017, SOFR was picked as the top choice to replace USD LIBOR by the Alternative Reference Rates Committee (ARRC)10. U.S. banking regulators then urged supervised entities to stop using USD LIBOR by December 31, 2021. By June 30, 2023, all USD LIBOR settings stopped, marking a big step towards SOFR10.
This change from LIBOR to SOFR took billions of dollars and millions of hours from the private sector and Congress10. SOFR deals now often go over $1 trillion a day10. The New York Fed plans to set up a new group in 2024 to keep SOFR rates trustworthy and efficient, and to push ARRC’s best practices10.
The ARRC suggested SOFR for many products but also said CME Group’s forward-looking SOFR term rates are needed for some old products and business loans10. The Paced Transition Plan included steps like building SOFR trading infrastructure, starting SOFR futures contracts, and clearing OIS referencing SOFR, with different deadlines, like 2019 Q1 and 2021 Q2, which was a big step in the switch10.
This change from LIBOR to SOFR also affected the world, as non-U.S. dollar LIBOR rates (GBP, JPY, CHF, EUR), along with the one-week and two-month USD LIBOR, stopped being published on January 1, 2022. USD LIBOR will fully end after June 30, 202311. More than $400 trillion of financial products are now affected by this change11.
SOFR, the new choice for USD LIBOR, comes from overnight borrowing in the repo market, with about $1 trillion in daily deals12. LIBOR, used in around $200 trillion of contracts, was based on a few market deals, raising doubts about its reliability and openness12. The move from LIBOR to SOFR is happening not just in the U.S. but also in major countries like the United Kingdom, European Union, Japan, Switzerland, and Canada, with their own alternative rates12.
“The transition from LIBOR to SOFR is a big task that needs careful planning and action from banks and regulators. Being proactive helps companies get ready for LIBOR’s end and switch smoothly.”11
| Country | Alternative Reference Rate |
|---|---|
| United Kingdom | Sterling Over Night Indexed Average (SONIA) |
| European Union | Euro Short-Term Rate (ESTR) |
| Japan | Tokyo Overnight Average Rate (TONAR) |
| Switzerland | Swiss Average Rate Overnight (SARON) |
| Canada | Canadian Overnight Repo Rate Average (CDOR transitioning to CORRA by YE 2024) |
Conclusion
The move from LIBOR to SOFR is a big change in finance. SOFR is now seen as a more trustworthy and clear benchmark interest rate. As more financial tools use SOFR, you need to update your systems to use it as the main US dollar benchmark13. SOFR’s steady, transaction-based nature has made it a top choice for regulators and market players14.
SOFR is becoming more popular, with13 $36 billion worth of debt issued by the end of 2018 and $265 billion by September 30, 2019. The CME Group started trading SOFR futures in May 2018, and now over 165 market participants trade these futures13. This shows how important SOFR is becoming in financial markets.
As LIBOR to SOFR transition continues, staying updated and proactive in treasury management is key. By adapting to SOFR’s reliability and transparency, you can confidently manage your organization’s finances in this changing landscape1415.
FAQ
What is SOFR?
SOFR stands for the Secured Overnight Financing Rate. It’s the main interest rate in the U.S. chosen by the Alternative Reference Rates Committee (ARRC). It’s a fully transaction-based rate from the Treasury repo market. This makes it more reliable and less open to manipulation.
How is SOFR different from LIBOR?
SOFR and LIBOR are different in many ways. SOFR comes from the Treasury repo market and is fully based on real transactions. LIBOR was based on what banks thought they’d pay to borrow money. SOFR is an overnight rate, unlike LIBOR’s various time periods. Also, SOFR is clearer and harder to manipulate than LIBOR.
How is SOFR calculated?
The New York Fed calculates SOFR. It uses the volume-weighted median of transactions in three markets: the tri-party repo market, the GCF repo market, and the bilateral Treasury repo market cleared by the Fixed Income Clearing Corporation’s Delivery vs. Payment Service. These markets involve borrowing and lending cash, secured by U.S. Treasury securities.
What are the different SOFR conventions?
There are several ways to calculate SOFR over time, like Daily Simple SOFR and SOFR Compounded in Arrears. These methods vary in how they use daily SOFR rates. Some rates are known at the start, others at the end of the period.
Why is the transition from LIBOR to SOFR important?
The switch from LIBOR to SOFR came because LIBOR was seen as unreliable and open to manipulation. This change is challenging, especially in the derivatives market. Companies with deals across borders need to know the interest rates used in each area.