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Understanding the Significance of the Secured Overnight Financing Rate (SOFR)
Once upon a time, the London Interbank Offered Rate, or LIBOR, was the de facto standard for setting interest rates on commercial and consumer loans globally. Yet, various scandals and a significant role in the 2008 financial meltdown led to its downfall. Taking the baton from LIBOR in the United States is the Secured Overnight Financing Rate (SOFR). Let's dig into SOFR, explore how it diverges from LIBOR, and discover the potential effects of this transition on you.
Getting to Grips with SOFR
SOFR is an influential benchmark that financial entities utilize to set prices on loans for both businesses and individuals. The "overnight financing" portion of its name hints at how SOFR sets rates for creditors—it's anchored on the rates that big financial institutions charge each other for overnight loans.
According to Sam Weller, Senior Vice President and Director of Capital Markets at Bryn Mawr Trust, SOFR offers a robust, transparent approach for setting a universal benchmark rate, relying on verified, processed transactions in the market. This element is crucial. Unlike LIBOR, which was based on rates financial institutions claimed to offer each other for short-term loans, SOFR factors in real lending transactions between institutions, making it less susceptible to insider manipulation.
As an authoritative interest rate, banks deploy SOFR to price U.S. dollar-based derivatives and loans. The daily SOFR is shaped by transactions in the Treasury repurchase market, where investors extend overnight loans to banks, backed by their bond holdings.
Benchmark rates like SOFR are vital in derivatives trading, especially for interest-rate swaps. These are employed by corporations and other entities to manage interest-rate risk and speculate on shifts in borrowing expenses.
SOFR in Action: How Does It Work?
Large financial institutions engage in lending among each other, using Treasury bond repurchase agreements, otherwise known as repos. These repos permit banks to extend overnight loans to meet liquidity and reserve requirements, with Treasurys serving as collateral. SOFR is the result of the weighted averages of the rates imposed on these repo transactions.
Each morning, the New York Federal Reserve Bank discloses the SOFR rate computed from repo deals from the prior business day. Since 2019, billions of dollars in floating-rate notes linked to SOFR have been issued in the United States, informs Ajay Patel, the Thomos S. Goho Chair in Finance at Wake Forest University's School of Business.
The Why: Replacing LIBOR with SOFR
From the mid-1980s, LIBOR was the go-to benchmark for loans. However, its reputation was tainted by a series of scandals and issues of inaccuracy due to manipulation. As Patel notes, the shrinking interbank lending market in recent years, with fewer transactions, led to the index reflecting quoted rates rather than real rates from deals. This meant the self-reported LIBOR rate did not accurately depict the true cost of borrowing.
SOFR is far less prone to manipulation as the Treasury repo market is one of the world's most liquid markets. Consequently, it relies on a greater volume of actual transaction data instead of self-reported hypothetical rates.
The Battle of Rates: SOFR vs. LIBOR
A crucial distinction between SOFR and LIBOR is that SOFR is based on finalized financial transactions, while LIBOR relied on quotes from reporting banks that didn't necessarily stem from real financial deals. However, there are additional differences to note.
A significant difference between LIBOR and SOFR, as noted by Patel, is that LIBOR was forward-looking while SOFR is backward-looking. This implies that while LIBOR allowed banks to know the borrowing rate at the onset of the period, SOFR, being backward-looking, means the borrower won't know their exact debt until the loan period ends.
Furthermore, Patel observes that LIBOR was unsecured—it didn't involve collateral—so it carried a credit risk premium. On the contrary, SOFR is a secured rate, built on transactions involving collateral, specifically Treasuries, so there's no credit risk premium included in the rates. Nevertheless, Patel foresees that some rates based on SOFR will incorporate a credit spread to better mirror pricing in adjustable-rate products.
Implications of SOFR for Individuals
Patel suggests that the transition from LIBOR to SOFR should leave little impact on most consumers. The transformation will primarily affect financial institutions. However, you might notice a change in the calculation of loan interest rates, which will now be based on SOFR instead of LIBOR.
While the transition from LIBOR to SOFR has already begun, it may take a few more years for the shift to fully materialize. Current LIBOR borrowing agreements will still persist within the financial system for some years, despite the switch to SOFR.
Special Considerations
In seeking alternatives to LIBOR, other countries have chosen different paths. The United Kingdom, for example, has selected the Sterling Overnight Index Average (SONIA) as its new standard for sterling-based contracts. The European Central Bank (ECB) chose the Euro Overnight Index Average (EONIA), based on unsecured overnight loans, while Japan has adopted its own rate, the Tokyo overnight average rate (TONAR).
A Snapshot of the Current SOFR Status
On June 1, 2023, the SOFR was listed at 5.08% according to the Federal Reserve Bank of New York.
LIBOR vs. SOFR: A Quick Comparison
SOFR measures the broad cost of overnight cash borrowing, backed by Treasury securities as collateral. LIBOR, on the other hand, was the rate banks employed to borrow from each other internationally—it was phased out in June 2023.
Is There a 3-Month SOFR Rate?
Although the Federal Reserve does not disclose a three-month SOFR rate, the Chicago Mercantile Exchange does publish one-, three-, six-, and 12-month Term SOFR rates for derivatives markets.
The Key Takeaway
The Secured Overnight Lending Rate (SOFR) is now the benchmark for interest rates on dollar-denominated loans and derivatives, replacing LIBOR in 2023. Unlike LIBOR, SOFR reflects an overnight rate, making it less susceptible to market fluctuations and manipulation.
