Secured Overnight Financing Rate (SOFR) is a secured interbank overnight interest rate and reference rate established as an alternative to LIBOR, which is published in a number of currencies and underpins financial contracts all over the world. Because LIBOR is derived from banks' daily quotes of borrowing costs, banks were able to manipulate the rates through lying in the surveys. Deeming it prone to manipulation, UK regulators decided to discontinue LIBOR.
As of 2021, SOFR is seen as the likely successor of LIBOR in the US. SOFR uses actual costs of transactions in the overnight repo market, calculated by the New York Federal Reserve. With US government bonds serving as collateral in the borrowing, SOFR is calculated differently from LIBOR and is considered a less risky rate. The less risky nature of SOFR may result in lower borrowing costs for companies.
Unlike the forward-looking LIBOR (which can be calculated for 3, 6 or 12 months into the future), SOFR is calculated based on past transactions, which limits the rate's predictive value on future interest rates. In addition, SOFR is overnight, whereas LIBOR can have longer tenors.
Global regulators decided to move away from the London interbank offered rate (Libor) -- a vital part of the financial system given that it’s linked to around $300 trillion of loans, derivatives and other instruments across various currencies -- after it was revealed in 2012 that banks around the world manipulated it. It also didn’t help that volumes underlying the benchmark dried up. U.K. regulators set the deadline at 2021 for financial firms and investors to transition away from the Libor.
In June 2017, US Federal Reserve Bank's Alternative Reference Rates Committee selected what's called the Secured Overnight Financing Rate, or SOFR as the preferred alternative to Libor. The committee has noted the stability of the repurchase market on which the rate is based. The New York Federal Reserve began publication of the rate in April 2018.
In August 2018, Barclays became the first bank to issue commercial paper tied to the rate; selling some US $525 million of short-term debt. Previously, Fannie Mae issued $6 billion securities tied to SOFR in July of 2018. Again in October 2018, Fannie Mae issued a second $ 5 billion securities that was also similarly tied to SOFR.
Nonetheless, weaning off the scandal-plagued Libor benchmark is a gigantic problem for global rates markets, one that increasingly looks too burdensome for a single replacement to handle in the U.S.
In July 2019, the SEC and the President of the New York Federal Reserve John Williams called on banks to swiftly transition from Libor to its replacements, such as SOFR, instead of waiting until the 2021 deadline. If a smooth transition from Libor cannot take place, smaller banks may reduce lending and companies may be less capable of hedging interest rate risks.
Companies are required to transition away from LIBOR on new contracts after Dec. 31, 2021, and for legacy contracts after June 30, 2023.
SOFR is based on the Treasury repurchase market (repo), Treasuries loaned or borrowed overnight. SOFR uses data from overnight Treasury repo activity to calculate a rate published at approximately 8:00 a.m. New York time on the next business day by the US Federal Reserve Bank of New York.
Unlike Libor, SOFR uses banks' actual borrowing costs rather than unverifiable estimates submitted by a panel of banks. However, it may still be vulnerable to manipulation. Banks can borrow and lend at biased rates in the wholesale funding market, which can lead them to profit in the much larger market for benchmark-indexed contracts. It was therefore suggested that the lending costs of individual banks be published to increase transparency and deter manipulation.
The Bank for International Settlements, which serves as the bank for central banks, said in March that a one-size-fits-all alternative may be neither feasible nor desirable. Although SOFR solves the rigging problem, it doesn’t help participants gauge how stressed global funding markets are. That means SOFR is likely to coexist with something else.
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