In June 2012, the financial world was rocked by a scandal that was likely decades in the making: Powerful United Kingdom-based Barclays, a universal bank involved in setting global financial rates, had been manipulating the system. Moreover, they were likely in cahoots with others.
The rate in question was the long-standing benchmark rate known as Libor (London interbank offered rate). Its purpose was to set the interest rates banks used when doing business among themselves, though it also impacted customer rates and therefore acted as a barometer for economic stability.
New concerns over its vulnerability to manipulation has the powers that be searching for a more reliable and transparent benchmark rate. And many have settled on the secured overnight financing rate, or SOFR. But what is it, and is it really any better than Libor?
What Is the Secured Overnight Financing Rate (SOFR)?
SOFR is a benchmark interest rate that reflects the cost of borrowing cash overnight, as collateralized by Treasury securities in the United States. That means there’s real money backing it up. It was introduced by the Alternative Reference Rates Committee to provide a more robust and reliable alternative to Libor.
LIBOR relied on self-reported interbank lending rates — the rates the banks were manipulating to mutual benefit. Rather than simply report the rate they lent money at, they got together to make the rates something mutually beneficial.
Basically, they could make the Libor number lower to make their bank more appealing to customers — and potentially look like they and the economy were in better shape than they really were. Plus, since they knew what it would be and when, they could time their trades.
But SOFR represents a shift toward a secured and transaction-based reference rate. Such a change addresses the vulnerabilities and manipulation concerns associated with LIBOR by basing it on real numbers used by real banks. They can keep calling each other and chitchatting about it, but now, they have to put their money where their mouths are.
Calculating SOFR
The powers that be calculate SOFR using a methodology that considers a wide range of overnight repurchase agreement (repo) transactions. Repos are agreements in which one party sells government securities — Treasury bills, bonds, and notes — to another, promising to buy them back later at a higher price. It’s essentially a low-risk way to borrow money temporarily (quite literally overnight).
The SOFR calculation uses transactions on the tri-party repo market, the general collateral finance repo market, and bilateral repo transactions. Though each of those operates slightly differently, they all involve using government securities as collateral for loans.
To get the SOFR, you take the volume-weighted median of those transactions. Volume-weighting ensures the more common transactions influence the number more heavily without discounting the lower-volume transactions.
These transactions provide a comprehensive and representative view of overnight borrowing costs in the Treasury collateral market.
Key Features & Characteristics
SOFR captures the true cost of borrowing in the overnight market, enabling market participants to accurately assess funding costs and make informed decisions. It has several unique characteristics that enable it to operate reliably and transparently.
- It all happens overnight. SOFR is an overnight rate, meaning it reflects borrowing costs for a 24-hour period. It provides timely information on borrowing costs, enables comparisons over time, and serves as a reliable benchmark that reflects real economic indicators.
- It’s collateralized. SOFR is backed by collateral in the form of Treasury securities. Since the transactions are secured, there’s greater stability and transparency compared to unsecured rates like Libor.
- It’s low-risk and stable. Basing the benchmark on low-risk Treasury securities reduces the potential for financial instability or shocks that could arise from using a more volatile or risky reference rate. In turn, that helps ensure the rates are fair and sustainable and provides stability, reliability, and confidence in financial markets, protecting investors and promoting a more secure financial environment.
- It’s transaction-based. Unlike Libor, which relies on banks’ submissions, SOFR is transaction-based. It is derived from observable market transactions. That means the money is always real and not subject to influence by shady dealers looking to pad their pocketbook by massaging the numbers.
- It’s publicly available. The transaction data used in SOFR’s calculation is publicly available, allowing market participants to understand the underlying market dynamics, have a clearer view of borrowing costs, and double-check the powers that be. Libor was essentially anecdotal, leaving it wide open to “creative interpretation.”
- It’s based on the secured funding market. Alignment with the secured funding market ensures SOFR accurately reflects the funding costs market participants face, enhancing its usefulness as a benchmark rate and preventing self-serving rate-fixing.
- It works with many financial instruments. SOFR is widely used as a benchmark rate in various financial transactions. It serves as a foundational reference for pricing and valuing financial instruments, including derivatives, loans, and securities. Its broad usage highlights its acceptance and recognition as a reliable benchmark.
Importance of SOFR as a Benchmark Rate (Over Libor)
The transition from Libor to alternative reference rates like SOFR is a global endeavor driven by the need for more reliable and robust benchmarks. Libor’s susceptibility to manipulation has had consequences, including reducing lending among banks.
Banks are more cautious about lending to one another thanks to poor decisions that caused the 2008 financial crisis. The crisis itself led to more stringent regulations, further compounding the issue.
The shift to SOFR ensures greater stability and integrity in the financial system, reducing the risks associated with Libor, which should energize lending, barring other financial dilemmas or disasters.
SOFR has gained widespread adoption as a benchmark rate in various financial transactions. It serves as a foundation for pricing and valuing financial instruments like derivatives, loans, and securities. Market participants use SOFR as a reference point to determine interest rates, reset terms, and calculate payments for these instruments.
Its broad usage reflects the industry’s recognition of SOFR as a reliable and representative benchmark.
Pros & Cons of SOFR
There’s no such thing as a perfect benchmark rate. While the pros outweigh the cons of SOFR, especially as compared to Libor, it’s important to understand exactly what SOFR can and can’t do.
Advantages of SOFR
When it comes to SOFR, the biggest advantage is that it isn’t Libor. As such, many of its advantages are inherent in its features. SOFR is:
- Robust, Realistic, and Observable. It’s based on actual transaction data from a diverse range of overnight repo transactions, ensuring a more reliable and accurate benchmark rate. It relies on observable market data rather than subjective bank submissions, reducing the potential for manipulation and enhancing integrity.
- Transparent. SOFR offers greater transparency compared to Libor. The transaction data it uses is publicly available, allowing market participants to understand the underlying market dynamics and have confidence in the benchmark’s reliability.
- Secure. SOFR represents borrowing costs backed by Treasury securities, making it a secured rate. That aligns closely with the secured funding markets and provides a more accurate reflection of borrowing costs. The collateralized nature of SOFR enhances stability, reducing the reliance on unsecured lending rates and lowering the risks associated with fluctuations in interbank borrowing.
- Low-risk. Backing the rate with reliable collateral helps mitigate the risks associated with the unsecured nature of Libor. By being collateralized, SOFR provides greater certainty and stability in the financial system. It reduces the potential for market disruptions and enhances the resilience of the benchmark rate.
- Resilient. The transition to SOFR contributes to building a more resilient financial system. The robust methodology, transparency, and secured nature of SOFR ensure a reliable benchmark rate that is less prone to manipulation and volatility, thereby enhancing the stability and integrity of financial markets.
- Aligned with real market conditions. SOFR closely reflects actual overnight Treasury security-backed borrowing costs. That provides market participants with a more accurate benchmark rate directly connected to funding costs, enabling better pricing, risk management, and decision-making.
- Popular. SOFR has gained significant support from regulators, central banks, and industry bodies globally. The backing of these entities provides confidence in the adoption and reliability of SOFR as a replacement for Libor, ensuring widespread acceptance and usage.
Disadvantages of SOFR
The advantages of SOFR can be blinding. But it’s not without challenges, and everyone should be well informed about the potential drawbacks. Fortunately, many of the disadvantages are temporary and have to do with the transition to SOFR itself. SOFR is:
- Resource-intensive (initially). The transition from Libor to SOFR requires changes across a wide range of financial systems that currently use Libor. Updating these systems to incorporate SOFR can be a complex and time-consuming process, requiring coordination among multiple stakeholders.
- Operationally complex (initially). Market participants must make operational adjustments to accommodate SOFR. That includes updating internal systems, models, and processes to calculate and apply SOFR-based rates. Implementing these changes can present operational challenges and may require investments in technology and resources.
- Time-consuming (initially). The transition to SOFR requires updating existing contracts and agreements that reference Libor. This process involves renegotiating and amending contracts. That and obtaining the necessary consent from counterparties can be a time-consuming and resource-intensive task.
- Disruptive (initially). During the transition period, there is a risk of market disruptions and potential market volatility. There may be temporary disruptions, pricing uncertainties, and liquidity challenges in certain financial markets. Efforts are underway to minimize these disruptions, but you can’t eliminate them entirely.
- Complex (initially). The successful transition to SOFR requires extensive coordination among market participants, regulators, and industry bodies. Ensuring consistent adoption and implementation across various sectors and jurisdictions is a complex task that requires collaboration, information sharing, and regulatory guidance.
- Risky (initially). There may be “basis risk” associated with the transition from Libor to SOFR. Basis risk refers to the potential mismatch or discrepancy between rates based on Libor and rates based on SOFR. Market participants need to carefully manage this risk and ensure appropriate adjustments or hedging strategies are in place.
- New and less reflexive (initially). The adoption of SOFR requires widespread education and awareness among market participants. Participants need to understand the nuances of SOFR, its calculation methodology, and its implications for their specific financial instruments and contracts. Education initiatives and outreach programs are crucial to facilitate a smooth transition.
Ongoing efforts by regulators, industry bodies, and market participants aim to address these challenges and ensure a successful transition to SOFR. These groups have created various working groups, guidelines, and best practices to provide guidance and support the industry throughout this process.
Final Word
It may not seem like benchmark rates affect regular people all that much. But they do.
They impact the interest rates on loans, such as mortgages, car loans, and student loans. When benchmark rates go up, borrowing costs tend to increase, making it more expensive for individuals to borrow money. Fortunately, the reverse is also true. That’s why the TV talking heads babble on about the federal funds rate so much.
Benchmark rates can also influence savings and investment returns. When benchmark rates are low, interest rates on savings accounts and fixed-income investments tend to be lower, while higher benchmark rates can provide better returns on savings and investments.
But even if none of that applies to you, benchmark rates can affect the overall economic environment. They impact factors like inflation, employment rates, and economic growth, which in turn can influence job prospects, wages, and the general cost of living for regular people.
So if you pay attention to no other financial indicators, pay attention to this one.