Secured Overnight Financing Rate (SOFR)

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The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities, published daily by the Federal Reserve Bank of New York, in cooperation with the U.S. Office of Financial Research starting on April 3, 2018.[1]

SOFR is an alternative to the London interbank offered rate (Libor). The New York Fed began publishing the rate as the first step in a multi-year plan to transition more derivatives away from Libor. SOFR is based on transactions in the underlying market, which trades around $800 billion in volume per day.[2][3]

The Alternative Reference Rate Committee (ARRC), a group of big banks, selected the rate, citing the depth and robustness of the market. The new rate was created partly in response to regulators seeking to reduce the markets' reliance on Libor, as there has been a decline in loans backing that rate. If Libor stops being published it could potentially pose systemic risks, according to Federal Reserve Chairman Jerome Powell.

Libor’s reputation was damaged when banks manipulated the rate before and during the 2007-2009 financial crisis. Libor rates are sometimes estimated rather than based on actual transactions.[4]

SOFR is designed to work alongside Libor, but regulators hope eventually more loans will be backed by the new rate and Libor's importance will decrease.

The CME Group launched 1-month and 3-month SOFR futures on the rate on May 7, 2018. [5]

LCH began clearing the first SOFR swaps in July 2018.[6]

However, there have been problems with the SOFR. For example, SOFR-based derivatives instruments have had trouble gaining traction; the Eurodollar Futures contact at CME Group traded roughly 1.8 million contracts ($1.8 quadrillion) on Jan. 29, 2019; the SOFR contract traded less than 1.2 thousand contracts ($1.2 trillion), according to the TABB Group, which also said there is basis risk associated with an interest rate like SOFR (overnight tenor and Treasury-related) because it is a backward-looking overnight rate and could play havoc with bank profitability during times of crisis.

References

  1. Secured Overnight Financing Rate Data. New York Federal Reserve Bank.
  2. New York Fed to launch U.S. Libor contender, slow takeup seen. Reuters.
  3. Goodbye LIBOR, Hello SOFR. Forbes.
  4. RPT-EXPLAINER-What is SOFR? The new U.S. Libor alternative. Reuters.
  5. What is SOFR?. CME Group.
  6. America's Libor Alternative Is Gaining Traction on Wall Street. Bloomberg News.