The Secured Overnight Financing Rate, commonly referred to as “SOFR,” is a benchmark rate index published by the Federal Reserve Bank of New York. It is used by financial institutions to price various lending products—such as loans, derivatives, and bonds—and reflects the average cost of borrowing funds overnight when secured by US Treasury securities. It was introduced as an alternative to LIBOR and is considered to be a more transparent and reliable benchmark rate index.
How Does SOFR Work?
Simply put, SOFR represents how much it costs to borrow money overnight. This scenario comes into play when financial institutions need to borrow money after business hours, or “overnight,” and essentially borrow funds from one another. SOFR uses collateral such as US Treasury bonds or other forms of government-backed collateral to secure the loan.
When determining the current rate, the SOFR is essentially the average interest rate of the overnight loans that are currently taking place. Instead of estimates, it is based on actual transactions within the repo A ‘repo’ is a short-term secured loan in which investors or dealers sell securities to another party and then buy them back at a higher price typically the following day. The difference in the initial and repurchase price reflects the interest paid on the loan, also known as the ‘repo rate.’ market and is updated daily to reflect changes that took place overnight.
How Is SOFR Calculated?
Calculating the SOFR is a very intricate process that involves the consideration of various sets of transaction data. According to the New York Fed, the SOFR is calculated by weighing the averages of transaction-level tri-party repo data, GCF Repo transaction data, and data on bilateral Treasury repo transactions cleared through FICC’s DVP service, which are gathered from the US Department of the Treasury’s Office of Financial Research (OFR).
For further details about the publication schedule and calculation methods behind SOFR, there’s a resource titled Additional Information about Reference Rates Administered by the New York Fed.
What Is the Current SOFR Rate?
SOFR updates are published every business day by the Federal Reserve Bank of New York at approximately 8:00 a.m. Eastern Time. Since rates are subject to frequent changes, you can reference current rate data by visiting the New York Fed’s SOFR data for the most up-to-date information. In addition to the daily rate, you can access historical data on how the rate has fluctuated over time.
SOFR vs LIBOR
SOFR | LIBOR |
|---|---|
Based on actual transactions | Based on estimates |
Secured by US Treasury securities | Unsecured, no collateral required |
Used for US dollar-denominated transactions | Used globally and inclusive of many currencies |
More reliable and transparent | Prone to manipulation |
SOFR was implemented as a replacement for LIBOR, or the London Interbank Offer Rate, which was a popular benchmark index rate that was phased out in 2023. This was due to LIBOR being influenced by scandals in which some banks were found to be manipulating the rate for the betterment of their own financial positions, which then led to further questioning regarding LIBOR’s transparency and calculations.
In turn, SOFR was developed as an alternative benchmark to mitigate the former vulnerabilities associated with LIBOR. Characteristics that make up SOFR are designed to protect rates from market fluctuations, increase transparency, and, ultimately, offer a more reliable benchmark for lenders to utilize.
These characteristics include:
- Calculations: SOFR utilizes actual transactions to generate the current rate, whereas LIBOR used estimates to calculate rates.
- Compliance: SOFR is compliant with international standards and best practices.
- Collateral: SOFR is secured by US Treasury securities, whereas LIBOR was unsecured.
- Currency: SOFR is a US dollar-denominated rate.
SOFR Transition
The transition to SOFR began on November 30, 2020, when the Federal Reserve announced that LIBOR was to be replaced by June 2023, although the two existed alongside each other up until LIBOR was phased out. As such, banks were then informed to discontinue issuing contracts that utilized LIBOR by the end of 2021.
How SOFR Is Used
SOFR is utilized by financial institutions to determine loan pricing and set applicable interest rates for various products. This can include adjustable-rate mortgages (ARMs), business loans, or other forms of debt that have a variable interest rate. This is usually calculated by adding the benchmark rate and the lender’s basis point margin to determine the interest rate.
That said, there are a few scenarios in which SOFR is commonly used, including:
- Financial product pricing: As mentioned, SOFR acts as a benchmark when pricing various financing products among financial institutions.
- Derivatives: SOFR is utilized for products that use US dollar-denominated transactions, such as swaps, futures, and options.
- Loan payment calculation: For financing that utilizes a variable rate of interest, the rate may fluctuate based on current market conditions and updated using the current SOFR.
- Short-term lending: SOFR is commonly used for loans that are borrowed overnight, or other forms of short-term financing.
Alternatives to SOFR
SOFR is just one type of benchmark rate lenders can use when determining the pricing of financing products. Some lenders may not even consider it as an option, depending on the financing type.
That said, similar benchmark rates include:
- Prime Rate is published by the Wall Street Journal (WSJ) and is another commonly utilized benchmark rate for well-qualified borrowers.
- Federal Funds Rate (FFR) is another benchmark rate set by the Federal Open Market Committee (FOMC) that represents the interest rate that US banks charge each other for overnight lending.
- American Interbank Offered Rate (AMERIBOR) is a benchmark rate that determines the true cost of short-term interbank borrowing and is set by The American Financial Exchange (AFX).
Frequently Asked Questions (FAQs)
No. While they are both overnight lending rates, they differ based on key factors such as collateral and the way they are calculated. SOFR uses US Treasury securities as collateral, whereas the FFR involves lending reserves between banks without collateral.
The main differences between SOFR and LIBOR lie in how they are calculated and their risk levels. Calculations for SOFR are based on actual market transactions, while LIBOR is calculated based on estimated borrowing costs. SOFR is also considered to be less of a risk since the loans that are used to calculate the benchmark rate are secured by US Treasury securities, whereas the loans used to calculate LIBOR had no collateral and were unsecured.
Yes. SOFR is considered to be more reliable than LIBOR and was implemented to be a more transparent benchmark. This is due to the fact that it’s based on actual market transactions, rather than estimated borrowing costs. This limits the capacity for potential manipulation, which previously was a prevalent concern in regard to LIBOR.
Bottom Line
SOFR is a commonly used benchmark rate that’s utilized by lenders to determine the pricing of lending products and is updated every business day. It replaced LIBOR in 2023, which was the previously utilized favored benchmark, and plays a key role in mitigating manipulatory practices and modernizing benchmark interest rates.
