Secured Overnight Financing Rate (SOFR)
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.
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.
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.
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 were problems initially with the SOFR. For example, SOFR-based derivatives instruments 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.
In August 2019, CME reported that more than 195 market participants had traded more than 63 million contracts since the May 2018 launch of SOFR futures. Open interest hit a record on August 30, 2019, surpassing 283,000 contracts.
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