Secured Overnight Financing Rate (SOFR) definition
What is the SOFR interest rate benchmark?
The Secured Overnight Financing Rate (SOFR) is the overnight interest rate for US dollar-denominated loans and derivatives. SOFR measures the cost to a bank of borrowing cash overnight, and so represents the amount of interest that a bank will have to repay to the lender the following day.
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How does SOFR work?
SOFR sets the rate at which banks can borrow cash from individuals or other banks overnight, on the premise that the borrower will pay the lender back the following day, along with the added interest from SOFR.
The rate is collateralised by the US treasury securities market – these are bonds issued by the US government. A bank will pledge treasuries as collateral to secure cash loans overnight, and as they are backed by the US government, they are usually seen as a good source of credit. They are therefore seen as a form of deposit insurance, which protects the lender’s cash from loss.
In April 2018, the New York Federal Reserve began calculating and publishing the SOFR rate – releasing the information daily at 8am EST (12pm UK time).
SOFR vs LIBOR
SOFR is the US replacement for LIBOR, which was subject to unfair manipulation for several decades. Other regions around the world are also replacing LIBOR with their own rates, such as ESTR for Europe and SONIA for the UK.
The main difference between SOFR and LIBOR is that SOFR is based on actual transactional data in the American treasuries market, while LIBOR is based on estimates provided by banks.
Pros and cons of SOFR
Pros of SOFR
As SOFR is based on transactional data, it is less prone to manipulation. This is especially true when compared to LIBOR, which was calculated from an average of the daily estimates for borrowing rates.
SOFR is released by the New York Federal Reserve – the de facto first-among-equals in the US Federal bank system – which implies impartiality and credibility.
Cons of SOFR
SOFR is only an overnight rate which is a serious drawback when compared to LIBOR. This is because LIBOR could be calculated in many different timeframes ranging from overnight to as long as 12 months.
Liquidity in the SOFR market is currently quite low compared to the liquidity levels under the LIBOR system, because LIBOR has been in more widespread use for a longer period of time. There is also a limited cash market under SOFR, but it is likely that this will develop as the rate becomes more widespread.
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