The secured overnight financing rate (SOFR) serves as a benchmark that shows the cost of borrowing money overnight, secured by U.S. Treasury securities in the repo market. Since it’s derived from real transactions, it represents a risk-free, secured rate that reflects current market conditions.
Initially, its overnight focus and absence of inherent credit risk made it tough to adopt. However, these issues have been tackled with the introduction of SOFR averages and the term SOFR created by the CME Group.
How Secured Overnight Financing Rate Works?
The Federal Reserve Bank of New York releases this benchmark rate every day, using a volume-weighted median method. This means that transactions with higher volumes have a bigger impact on the rate. When it comes to rates with different terms, you can refer to SOFR averages and term SOFR for loans, bonds, and derivatives.
The History
For a while, the London Interbank Offered Rate (LIBOR) was the go-to standard for global interest rates. But due to its dependence on banks’ estimates instead of actual transactions, along with some scandals in the early 2010s, regulators decided it needed to be replaced. That’s when SOFR came into the picture.
Conclusion
SOFR has become the preferred benchmark for USD-denominated financial products, taking over from LIBOR with a clearer, more dependable, and transaction-focused method.
Although the shift came with its hurdles, such as the absence of a built-in credit risk component and the initial lack of term structures, market developments like the introduction of term SOFR and spread adjustments have made the transition easier.