Secured Overnight Financing Rate (SOFR) is the secured overnight funding rate in USD.

It is a rate published by the New York federal reserve based upon secured overnight transactions in the repo market.

It is of increasing importance since it has been regarded by many market participants as the basis for the likely successor to U.S. dollar LIBOR.

SOFR is based on transactions in the Treasury repurchase market, where banks and investors borrow or loan Treasuries overnight.

A group of large banks, the Alternative Reference Rate Committee (ARRC), selected the rate as an alternative to the London interbank offered rate (LIBOR) in derivatives.

It cited the depth and robustness of the market where around $800 billion is traded daily.

Regulators including Federal Reserve Chairman Jerome Powell are seeking to reduce markets’ reliance on LIBOR due to a decline in loans backing the rate.

The LIBOR underpins $200 trillion in derivatives and loans, underscoring the necessity of promoting a robust alternative. Derivatives account for 95 percent of the exposures.

Reforms to banking and money market fund regulations resulted in fewer interbank short-term loans and reduced demand for bank debt.

Also, Libor’s reputation was damaged by charges that banks manipulated the rate before and during the 2007-2009 financial crisis, often to book larger profits on derivatives based on the rate.

LIBOR rates are sometimes estimated rather than based on actual transactions.

Will SOFR replace LIBOR?

SOFR is intended to work alongside LIBOR.

Over time, regulators hope that more derivatives and loans will be backed by the rate, which will decrease the importance of Libor.

The New York Fed’s publication of the rate is the first in a series of steps to enable a transition.

Major dealers and clearinghouses that guarantee interest rate swap trades are also working to enable swaps based on the new rate.

Regulators want to retire LIBOR with a full phase-out by the end of 2021.

At that point, all dollar-denominated loans, derivatives, and debt will reference a new rate, the Secured Overnight Funding Rate (SOFR) which is a median of rates that market participants pay to borrow cash on an overnight basis, using Treasurys as collateral.

What is LIBOR?

LIBOR is a benchmark for short-term interest rates, ranging from overnight to one year, across many different currencies.

Its origins are said to go back to 1969, when a Greek banker arranged a syndicated loan linked to the reported funding costs of banks, though it wasn’t formalized until the British Bankers’ Association began overseeing the collection and governance of this data nearly two decades later.

Fast forward, and today LIBOR has a critical role in global markets: It is now widely used as a reference rate for financial contracts and as a benchmark to gauge funding costs and investment returns for a broad range of financial products, including adjustable-rate mortgages, credit cards, floating-rate bank loans, and interest rate swaps.

In addition, variations in the “spread” between LIBOR and other benchmarks indirectly act as a key indicator of changing investor sentiment in global financial markets.

Why Replace LIBOR?

Global markets have grown in size and complexity. Yet, the methodology for calculating LIBOR rates has remained largely unchanged:

Each day a group of large banks, known as panel banks, report their funding rates to the Intercontinental Exchange Benchmark Administration (IBA), which took over administering LIBOR in 2014.

Those numbers are averaged, adjusted, and released at approximately 11:45 a.m. London time each business day.

This process is outdated in the best of circumstances, but the bigger concern is the significant decline in sample size for calculating LIBOR since the 2008 financial crisis.

In its aftermath, fewer panel banks have been reporting, and those that do are reporting fewer transactions. Instead, LIBOR has increasingly relied on what the IBA calls “market and transaction data-based expert judgment.”

As a result, in 2014 the U.S. Federal Reserve commissioned the Alternative Reference Rate Committee (ARRC) to recommend a benchmark interest rate to replace USD LIBOR, or the short-term reference rate for dollar-denominated debt.

What is LIBOR’s Replacement?

For dollar-denominated loans and securities, that new benchmark is SOFR, which is based on transactions in the U.S. Treasury repurchase, or repo, market, where banks and investors borrow or lend Treasurys overnight. The Fed began publishing SOFR in 2018.

It’s worth noting that other countries are introducing their own local-currency-denominated alternative reference rates for short-term lending, but SOFR is expected to supplant USD LIBOR as the dominant global benchmark rate.

Alternatives to LIBOR

Regulators have pushed internationally to find alternatives to Libor and its equivalents.

A British committee last year selected SONIA, an unsecured overnight lending rate, as an alternative to sterling-based Libor

Japan selected TONAR as an alternative to yen Libor, also an unsecured rate.

A group in Switzerland selected SARON, a collateralized rate based on the Swiss repo market.

The European Central Bank (ECB) is developing a daily euro unsecured overnight index rate.

Country LIBOR Rate New Risk-Free Rate Transition Committee
United States USD LIBOR SOFR Alternative Reference Rates Committee
United Kingdom GBP LIBOR SONIA Sterling Working Group on Risk-Free Rates
Japan TIBOR, JPY LIBOR and Euroyen TIBOR TONA Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks
Europe EURIBOR and EUR LIBOR ESTER European Money Markets Institute (EMMI) and Euro RFR Working Group
Canada CDOR CORRA Canadian Alternative Reference Rate Working Group (CARR)
Switzerland CHF LIBOR SARON The National Working Group on Swiss Franc Reference Rates
Australia BBSW RBA Cash Rate (AONIA) Australian Financial Markets Association
Hong Kong HIBOR HONIA Treasury Markets Association’s Market Practices Committee

How Does SOFR Differ From LIBOR?

Both SOFR and LIBOR reflect short-term borrowing costs, but key differences between them make the transition tricky.

First of all, SOFR relies entirely on transaction data, whereas LIBOR is based partially on market-data “expert judgment.”

Secondly, SOFR is purely a daily rate—what’s called an overnight rate—vs. LIBOR’s seven varying rates in terms of one day to one year.

Finally, LIBOR incorporates a built-in credit-risk component because it represents the average cost of borrowing by a bank.

In contrast, SOFR represents a “risk-free” rate because it is based on Treasurys.

Given these differences, USD LIBOR can’t simply be “swapped out” with SOFR in existing contracts that reference LIBOR—at least not without appropriate adjustments.

This is where things get complicated.

To account for the differences in SOFR and LIBOR during the transition—and in the event that LIBOR sunsets before 2021—regulators are encouraging institutions to include “fallback” clauses in all new contracts.

These clauses outline exactly how differences between SOFR and LIBOR will be calculated.

What Is the Timing of the Transition?

USD LIBOR’s formal retirement is set for the end of 2021—but that timeline isn’t absolute. It’s possible that rates based on LIBOR could continue to be published after that point.

However, it’s also possible that LIBOR will effectively end before 2021 if the number of panel banks reporting to LIBOR—currently between 11 and 16—falls below four.

Meanwhile, the transition has already begun, albeit slowly, with some U.S. institutions issuing securities and writing contracts that reference SOFR.

A tipping point for SOFR could happen next year when central clearinghouses begin using SOFR discounting on all dollar-denominated interest rate swaps.

As more derivatives reference SOFR, it will likely spur broader adoption of SOFR.

Should Investors Worry?

The end of LIBOR has been referred to by some pundits as the financial market equivalent of Y2K—the time-boxed tech scare that assumed the world’s computers would shut down as 1999 turned to 2000—but the transition is meant to be gradual and measured.

Perhaps the biggest risk is that LIBOR will end prematurely, either because the number of panel banks falls below the required minimum or because regulators trigger an early end.

While unlikely—because panel banks and regulators have a vested interest in a smooth transition—it could disrupt the financial system if adequate fallback clauses aren’t already in place.

Even in the best circumstances, valuation differences are likely to arise, particularly for interest rate swaps and derivatives.

For this reason, investors with sizable books of swaps will want to carefully manage these risk months before the switch deadline and prepare operational and trading capabilities for SOFR-linked derivatives products.