This Treasury repurchase market is much larger than the interbank loan market that LIBOR used. This distinction is crucial because SOFR’s reliance on real transactions makes it less prone to Roboforex Review the kind of manipulation that plagued LIBOR. Although SOFR offers several benefits for financial institutions, it’s not without downsides.
What Is the Secured Overnight Financing Rate (SOFR)?
- For a multinational corporation, even a tiny percentage return on such loans can represent a lot of money.
- In response, regulators, particularly in the U.S., took steps to replace LIBOR.
- Use cases for daily compounded SOFR include financial products and contracts where the interest is expected to compound daily.
- SOFR can also be used to calculate floating rates based on reference rates.
- The main objective of this committee was to find a new benchmark rate.
Its role in providing stability and transparency is growing, poised to become a foundational element in financial markets and shaping a more resilient and transparent financial future. In the United States, SOFR has replaced LIBOR as the standard reference rate. Other countries use alternative financial benchmarks such as SONIA or ESTER. This type is calculated daily and takes into account the interest accrued — providing a comprehensive view of the total borrowing cost over a particular interest period. Use cases for daily compounded SOFR include financial products and contracts where the interest is expected to compound daily.
It is most commonly used in interest-rate swaps, where two parties agree to exchange interest payments based on fixed and floating rates. For example, in a standard swap, one party agrees to pay a fixed interest rate, while the other party pays a floating rate based on SOFR. If SOFR rises, the floating-rate payer benefits, as the incoming SOFR-based payments increase. The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
LIBOR’s Dominance and Downfall
- The company swaps its floating-rate loan for a fixed-rate loan with Bank A, a counterparty.
- You may not follow it from day to day, but if you’ve had a credit card, a loan, or an adjustable-rate contract, you’ve likely crossed paths with SOFR or its predecessor, LIBOR.
- LIBOR was a popular benchmark rate based on what banks typically charged each other for short-term loans.
- This market is one of the most liquid and deep markets globally, providing a reliable basis for determining SOFR.
SOFR’s calculation uses data from a broad spectrum of repo transactions, ensuring a comprehensive market representation. This variety in data sources contributes to SOFR’s stability and reliability, making it a crucial tool for financial decision-making and policy development. The secured overnight financing rate (SOFR) is a standard, short-term, market-based interest rate that quietly underpins a significant—and growing—portion of the financial system. You may not follow it from day to day, but if you’ve had a credit card, a loan, or an adjustable-rate contract, you’ve likely crossed paths with SOFR or its predecessor, LIBOR. Knowing what it is can help you understand what’s driving the rates that affect you. The secured overnight financing rate (SOFR) is a rate that reflects the cost of borrowing overnight, backed by U.S.
By relying on actual market transactions rather than estimates, SOFR offers a more transparent and reliable measure of borrowing costs. Its introduction has helped restore confidence in benchmark rates, ensuring that financial products tied to interest rates are grounded in observable data and less prone to manipulation. The secured overnight financing rate (SOFR) is an interest rate calculated by the Federal Reserve Bank of New York based on the overnight borrowing cost for secured funds (i.e., those backed by Treasury securities). It replaced the London interbank offer rate (LIBOR) as the standard benchmark for short-term borrowing among banks. SOFR is often specified in contracts—from swaps and OTC derivatives to your credit card agreement—as the basis for interest rate changes.
Federal Reserve Economic Data
These benchmarks, like SOFR, are based on actual transactions, making them more reliable than the previous LIBOR system. In response, regulators, particularly in the U.S., took steps to replace LIBOR. In 2017, the Federal Reserve created the Alternative Reference Rates Committee (ARRC), which selected SOFR as the replacement for LIBOR. The Federal Reserve Bank of New York began publishing SOFR in April 2018 to help financial institutions transition away from LIBOR.
With SOFR, a creditor may use the daily compounded interest or the SOFR index value to calculate the interest rate on a loan. In 2014, the Federal Reserve Bank of New York convened an Alternative Reference Rates Committee to investigate other interest rates that could replace LIBOR. Congress passed the Adjustable Interest Rate (LIBOR) Act, which made SOFR the replacement rate for any contracts that specified LIBOR effective June 30, 2023. It uses the daily settlement prices of those futures contracts to calculate and publish the CME Term SOFR Rates, which are forward estimates for SOFR rates that look out one, three, six, and 12 months. Financial institutions and corporations can use that data in their financial planning and risk management.
The Impact of Secured Overnight Financing Rate
The rate is used by other banks, financial companies, and corporations when setting interest rates. For example, a contract may call for an interest rate based on a multiple of SOFR, or an adjustable-rate mortgage may move based on changes in SOFR rates. Banks need to meet federally mandated capital reserve requirements each night.
CME Term SOFR
The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans. Major central banks globally have taken on similar reforms to replace their US LIBOR equivalents with more reliable rates. Financial service providers use SOFR to price USD derivatives and loans. For example, mortgage holders with loans based on SOFR could see changes in their interest rates when their loan resets, depending on fluctuations in SOFR. SOFR averages are measured by compounding rates over consecutive 30-, 90-, and 180-day intervals.
Because these loans happen on a regular basis on short notice, any rapid fluctuation in the overnight rate may signal a pending change in the economy. It’s an important rate used by financial services companies every day to set the interest rates that you might be paying. Learn about SOFR—how it’s calculated and why and when it fluctuates—to help you understand why, say, the interest on your credit card may have changed. While the transition had some challenges, including the lack of a built-in credit risk part and the initial absence of term structures, market changes like introducing term SOFR and spread adjustments have smoothed adoption. The latest published SOFR 1-month, 3-month, and 6-month averages are for November 5, 2025. Note these term rates are calculated in arrears (they average historical SOFR rates) as opposed to being forward-looking like swap rates.
Is SOFR replacing LIBOR?
One major concern is that SOFR only looks at secure overnight deals and doesn’t consider credit risk, meaning the SOFR rate may drop in the event of an economic downturn. In theory, this could influence the Federal Reserve’s decisions on adjusting the federal funds rate, which could impact SOFR and other risk-free rates. It was based on the average interest rate at which major global banks borrowed from one another, most notably using the three-month U.S. dollar LIBOR rate. However, LIBOR’s vulnerability became evident following the 2008 financial crisis.
Its advent marks a shift from legacy benchmarks like LIBOR to a more transparent, transaction-based model, enhancing its reliability in financial operations. Overnight financing rates, such as SOFR, are key indicators of short-term borrowing costs. Derived from real transactions, SOFR offers insights into market liquidity and financial stability, reflecting the current state of the lending and borrowing environment. The Secured Overnight Financing Rate (SOFR) has successfully replaced LIBOR as the benchmark rate for U.S. dollar-denominated loans and derivatives.
What are SOFR Alternatives?
Corporations need to meet every financial obligation, including payroll. But both banks and corporations have wide fluctuations in the amount of cash they have on hand on any given day. Sometimes a company (or a bank) has more money than it needs, so it will lend it out overnight to another entity that needs to borrow overnight. For a multinational corporation, even a tiny percentage return on such loans can represent a lot of money.