Understanding Secured Overnight Financing Rates

The secured overnight financing rate (SOFR) is an important benchmark rate that reflects the average interest rate banks pay to take out secured loans in U.S. dollars overnight. The loans are secured by U.S. Treasury bonds. The SOFR is important to investors because it impacts the price of derivatives and loans that are based in U.S. dollars. 

In June 2023, the SOFR replaced the London Interbank Offered Rate (LIBOR) for several reasons. The SOFR reference rate is based on an observable metric, as opposed to the future rate predictions that were the basis of the LIBOR. The SOFR’s basis in current rates means it is less apt to be affected by market manipulation than the LIBOR. 

What Are Secured Overnight Financing Rates?

When banks value derivatives and loans that are based in U.S. dollars, they need an objective benchmark that both parties of the transaction agree to. The SOFR fluctuates daily based on the repurchase market, (which is where investors lend money overnight to banks and banks secure the loans with their bond holdings) for U.S. Treasury Bonds.  

The higher the interest rate banks pay to borrow the money they lend to consumers, the more it will cost borrowers to finance a loan. The higher the SOFR your bank is paying, the higher the interest rate they charge you for financing. 

When credit is cheap, individual borrowers can secure more capital to make large purchases or investments like homes. It allows investors to borrow or leverage more money for bigger projects like venture capital investments or new real estate developments. 

How Does the SOFR Work?

The SOFR is an important component of derivatives trading, especially when it comes to the interest rate swaps that big companies use to mitigate risk and predict the cost of credit in the future. In an interest rate swap, one institution, company or group of investors pays a fixed interest rate to buy another company or bank’s debt. 

The company that receives the money agrees to pay back the money from the first institution with an adjustable or floating interest rate that is based on a mutually agreeable reference rate, such as the SOFR. The initial rate could be slightly higher or lower than the SOFR based on the borrower’s credit rating, cash reserves and current interest rates. 

If the SOFR goes up in the period after the loan, the original lender makes more money because the benchmark interest rate for the original loan has increased. If the SOFR goes down, the borrower wins because paying back the loan will cost them less money interest.

Background of the SOFR

The SOFR is not the first benchmark rate that has been used for interbank lending. Prior to the SOFR, banks used something known as the LIBOR. The LIBOR rate included was an estimated measure of the interest rate that the world’s largest global banks would extend to each other when doing financial transactions. 

The LIBOR consisted of seven maturities and the following global currencies:

• U.S. dollar
• Euro
• Great British pound
• Japanese yen
• Swiss franc

For much of its history, the LIBOR rate that was quoted was the three-month rate for the U.S. dollar. However, the LIBOR had one significant potential drawback — it was not necessarily based on any specific transactions and was instead a mutually agreed upon rate between the participating banks. This method was imprecise at best and at worst, created a system that was easy for just a few actors to manipulate. 

Then in 2012, it became clear that some participating LIBOR banks were all cooking their books in such a way that allowed them to charge higher rates. This cooperative manipulation allowed participating banks to significantly increase profits made by derivatives trading. 

Another issue made the LIBOR a less accurate benchmark by 2012. The financial crisis, and the flurry of federal regulations that came about in its aftermath, meant that banks were doing a lot less interbank lending. That meant there weren’t really enough transactions for there to be an accurate LIBOR. All of this prompted Britain’s top banking regulatory authority to announce they were scrapping the requirement that banks submit their interbank lending records to the regulator.  

The Federal Reserve Responds

The British bank regulator’s decision to suspend LIBOR reporting requirements was essentially the end of the LIBOR as a reference rate. The Federal Reserve responded to the impending end of the LIBOR rate by forming the Alternative Reference Rate Committee. 

This committee, which was made up of several of America’s largest banks, was tasked with coming up with a new benchmark. They chose the SOFR. In April 2018, the Federal Reserve Bank of New York began to publish the SOFR. Then in November 2020, the Federal Reserve announced a plan to slowly phase out and then eliminate the LIBOR altogether. 

Specifically, it instructed banks to stop making deals based on the LIBOR by the end of 2021. They also said that as of June 2023, the SOFR would replace the LIBOR completely. That’s how the secured overnight finance rate became the new benchmark for interbank lending, derivatives and rate swaps.

How is the SOFR Calculated?

The SOFR is based on several metrics, all of which are observable. The New York Federal Reserve calculates the daily SOFR by taking the average price for repo contracts that are secured by U.S. Treasury bonds on a given day. The 30-day rate is the average SOFR for a one-calendar-month period. 

What Are the Applications of the SOFR?

The SOFR’s status as the rate at which banks conduct transactions with each other means it has several important applications in both investing and consumer products. In terms of investing, the rates in the derivatives market are frequently tied to benchmarks such as the SOFR. 

When it comes to consumer credit products, the SOFR has an impact in several areas, some of which include:

• Adjustable-rate mortgages
• Student loan rates

In the case of adjustable-rate mortgages, if the SOFR has increased when the fixed interest rate period on their loan expires, the new rate will be higher. If it has gone down, the borrower’s rate may decrease. The SOFR is also a reference rate for the interest on student loans. 

Advantages and Disadvantages of the SOFR

Perhaps the biggest advantage the SOFR offers the financial markets is that it’s based on an observable set of trades that everyone can see. There is almost always a robust repo market for U.S. Treasury bonds. That means the SOFR will almost always have an accurate, empirically derived set of market fundamentals underpinning its numbers. 

That basis in daily numbers also makes the SOFR less susceptible to the kind of market manipulation that raised doubts about the LIBOR in the first place. A significant part of the LIBOR rate was based on banks speculating how much it might cost to do a particular transaction, as opposed to the actual cost. Participating SOFR banks can’t just agree among themselves about how much they will report their rates to yield a specific outcome (as happened with LIBOR).

However, it does have potential downsides. The SOFR being based on daily transactions instead of a long time period can lead to volatility in rates. This is especially true at the end of quarters and fiscal years. Many financial products have reacted to this volatility by using an average of SOFR rates from a particular time period. 

Also, the SOFR’s reliance on previous contracts means it’s almost exclusively a backward-looking metric. The SOFR is tied to U.S. Treasury bonds, which means the credit risk is with the U.S. bonds and not between the borrowing banks.

LIBOR vs. SOFR

A quick summary of the LIBOR vs. the SOFR as benchmark rates follows 

Libor

• Old system 
• Based on estimates of the future cost of interbank lending
• Forward-looking
• Highly speculative
• Subject to manipulation
• Credit risk tied more to borrowing bank
• LIBOR is the rate for unsecured borrowing

SOFR

• New system as of June 2023
• Based on overnight transaction rates in the Treasury Bond Repo Market
• Backward-looking
• Credit risk tied more toward U.S. Treasury Bonds
• Less prone to manipulation than LIBOR
• Can be more volatile than LIBOR

Transition from LIBOR to SOFR

The transition from the LIBOR to SOFR as the benchmark was completed in June 2023. The phaseout of LIBOR was due to several reasons, such as the speculative nature of LIBOR rates making them subject to manipulation. Another factor was the relative lack of interbank transactions after the financial crash, which created a situation where it was difficult to be sure LIBOR rates were reliable. 

Once Britain announced it would no longer require banks to submit LIBOR information, reserve banks around the world set about coming up with their own benchmark rate formulas for interbank lending. The Federal Reserve adopted the SOFR, which was based on the average price of overnight trading of Treasury bonds. 

The SOFR is more volatile than the LIBOR, which has led some banks to use an average SOFR rate across a given period (such as 30 days) as a benchmark on interest rate swaps or derivatives contracts. However, the increased volatility of the SOFR does have the potential to increase consumer borrowing costs.

Impact of SOFR on Borrowers and Lenders

Whenever something as important as the benchmark lending rate between banks changes, there is bound to be an effect on both borrowers and lenders. Lenders relying on the secured overnight finance rate now have a reference rate that is more stable and less subject to manipulation than the old LIBOR. Theoretically, this should make for more accurate cost estimates when banks borrow from each other. 

However, the SOFR’s increased volatility and the fact that it largely looks backward to predict future transactions could result in banks tightening their credit standards. It could also mean borrowers with adjustable interest rates may see more rate increases throughout the terms of their loan. For example, when the fixed interest period that ends on an adjustable-rate mortgage right comes into effect under SOFR, it’s likely the new rate will be much higher. 

The SOFR and Your Finances

If you’re a retail banking customer, the most important benchmark rate you know is probably the prime lending rate at which the Federal Reserve lends money to other banks. This metric is important, but the SOFR can have an impact on everything from credit card interest to the refinance terms on a student loan or an adjustable-rate mortgage. As an investor, the SOFR has an effect on derivatives trading and credit swaps. 

If you understand what the SOFR and how it works, you can track it and perhaps use the data you uncover to identify trends in the derivatives or credit swap market. Either way, now that it’s replaced the LIBOR benchmark rate for interbank lending, the SOFR is something you should monitor. It will give you insight into the state of the economy and could potentially improve your trading decisions.

No matter what your financial situation, the conversion from the LIBOR to the SOFR is going to be something you feel in your pocketbook. It’s a new benchmark whose long-term effects on the economy remain to be seen. So, stay alert and watch the market closely. There could be some tremendous opportunities out there.

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