Secured Overnight Financing Rate (SOFR)
Tue, Apr 15The Secured Overnight Financing Rate (SOFR) serves as a benchmark interest rate that indicates the cost of borrowing cash overnight, secured by U.S. Treasury securities. It is calculated by the Federal Reserve Bank of New York based on actual transactions occurring in the Treasury repurchase market. Introduced in April 2018, SOFR was developed as an alternative to the London Interbank Offered Rate (LIBOR) due to its transparency, robustness, and reduced risk of manipulation. LIBOR has faced criticism for its vulnerability to manipulation and is being phased out in favor of rates like SOFR.
What is SOFR? The Secured Overnight Financing Rate (SOFR) is a reference rate that quantifies the average interest rate banks pay to borrow funds overnight from other banks, using Treasury securities as collateral. SOFR was created by the Federal Reserve Bank of New York in collaboration with the U.S. Office of Financial Research in response to the controversies surrounding LIBOR, including rate-rigging scandals and concerns regarding the sustainability of the interbank lending market. It is based on transactions in the U.S. Treasury repurchase agreement (repo) market, which involves short-term secured lending among financial institutions. SOFR is regarded as a more reliable and transparent benchmark rate compared to LIBOR, which relies on estimates of what banks would charge each other for loans.
How does SOFR work? SOFR is calculated daily using a volume-weighted median of transaction-level repo data. This methodology ensures that the rate accurately reflects a broad measure of overnight borrowing costs in the secured market. In contrast to LIBOR, which is based on expert opinions from a panel of banks, SOFR is derived from actual transaction data, enhancing its transparency and reducing its susceptibility to manipulation.
Why is SOFR important? The shift from LIBOR to SOFR has gained traction as regulators and market participants acknowledge the necessity for a more robust and transparent benchmark rate. SOFR is now utilized for various financial instruments, including loans, mortgages, bonds, and derivatives. Here are some advantages of SOFR: it is grounded in actual transactions within the Treasury repurchase market, making it more reliable than LIBOR, which relies on estimates; it offers greater transparency, as the data used for its calculation is publicly accessible; and it is more liquid than LIBOR, given the abundance of Treasury securities available for collateral.
However, there are some disadvantages to SOFR: it is a relatively new rate, resulting in less historical data compared to LIBOR; it is based on overnight transactions, which may not accurately reflect longer-term interest rates; and it is not as widely adopted as LIBOR, potentially leading to lower liquidity in SOFR-based products.
Who publishes the SOFR? The Federal Reserve Bank of New York publishes SOFR daily, based on the transactions from the previous day in the U.S. Treasury repo market. This data is made available on their website, ensuring that market participants have easy access to the most current information.
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