What Is the Secured Overnight Financing Rate (SOFR)? The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans. It replaced the London Interbank Offered Rate (LIBOR) in June 2023. SOFR offers fewer opportunities for market manipulation and provides current rates rather than forward-looking rates and terms.
Key Takeaways: SOFR is a benchmark interest rate for dollar-denominated derivatives and loans that replaced LIBOR. It is based on transactions in the Treasury repurchase market and is preferable to LIBOR as it uses data from observable transactions instead of estimated future borrowing rates. While SOFR became the benchmark rate for dollar-denominated derivatives and loans, other countries have sought their own alternative rates like SONIA and EONIA.
For one, the LIBOR was largely based on estimates from global banks surveyed but not on actual transactions. The downside of this became apparent in 2012 when more than a dozen financial institutions were revealed to have fudged their data for bigger profits from LIBOR-based derivative products.1 In addition, post-financial crisis banking regulations led to less interbank borrowing, making the LIBOR less reliable. Eventually, the British regulator said it would no longer require banks to submit interbank lending information after 2021. This led developed countries to search for an alternative. Federal Reserve Action In 2017, the Federal Reserve assembled the Alternative Reference Rate Committee to select an alternative for the United States. The committee chose the Secured Overnight Financing Rate (SOFR).2 The Federal Reserve Bank of New York began publishing the SOFR in April 2018.2 SOFR vs. LIBOR Unlike LIBOR, there’s extensive trading in the Treasury repo market, making SOFR a more accurate indicator of borrowing costs.3 Moreover, SOFR is based on observable transactions rather than estimated or falsified borrowing rates like LIBOR.4 Transitioning to the SOFR On Nov. 30, 2020, the Federal Reserve announced the phasing out of LIBOR and its replacement by June 2023. Banks were instructed to stop writing contracts using LIBOR by the end of 2021.5 The LIBOR and SOFR coexisted until June 2023 when SOFR became the standard in the U.S. Transition Challenges The move to SOFR is expected to impact the derivatives market and also play an important role in consumer credit products and debt instruments. For adjustable-rate mortgages based on SOFR, the benchmark rate determines borrowers’ payments. If the SOFR is higher when the loan resets, homeowners pay a higher rate. Special Considerations Other countries have also sought alternatives to LIBOR. The United Kingdom chose the Sterling Overnight Index Average (SONIA). The European Central Bank opted for the Euro Overnight Index Average (EONIA), and Japan has its own Tokyo overnight average rate (TONAR).
What is the current Secured Overnight Financing Rate (SOFR)? As of June 1, 2023, the SOFR was 5.08%, according to the Federal Reserve Bank of New York.6 What’s the difference between LIBOR and SOFR? SOFR measures the broad cost of overnight cash borrowing, using Treasury securities as collateral. LIBOR was the rate banks used to borrow from each other internationally. It was sunsetted in June 2023.76 Is there a 3-month SOFR rate? The Federal Reserve does not publish a three-month SOFR rate. However, the Chicago Mercantile Exchange publishes one-, three-, six-, and 12-month Term SOFR rates for derivatives markets.8 The bottom line: The Secured Overnight Lending Rate (SOFR) is the benchmark for interest rates on dollar-denominated loans and derivatives. It replaced the London Intrabank Offered Rate in 2023. SOFR was adopted as the globally accepted rate. SOFR reflects an overnight rate, while LIBOR was a forward-looking rate. This makes SOFR much less susceptible to market fluctuations and manipulation.
