Secured Overnight Financing Rate (SOFR)
What Is Secured Overnight Financing Rate (SOFR)?
The Secured Overnight Financing Rate (SOFR) is an interest rate benchmark chosen by the Alternative Reference Rates Committee (ARRC) in 2017 as an alternative and eventual replacement for the London Interbank Offered Rate, more commonly known as Libor, which is slated to be phased out by 2021.
ARRC is a committee set up by the U.S. Federal Reserve Board and the Federal Reserve Bank of New York to identify a risk-free alternative for Libor and create an implementation plan for it. ARRC is made up of representatives from private-sector banks, asset managers, insurers and industry trade organisations. The ARRC is chaired by Tom Wipf, vice chairman of institutional securities at Morgan Stanley.
Libor has been used to set interest rates on a variety of floating-rate consumer and business loans and securities for decades, and it has fallen out of favour for two reasons. During the financial crisis, several banks tried to manipulate Libor and then profit from it. They also tried to hide their risks by submitting lower figures. Since 2012, regulators in the U.S., the U.K. and the European Union have fined banks more than US$9 billion for trying to rig Libor.
Partly as a result of this behaviour, the transaction volume of loans and securities tied to Libor has dropped, which led the financial industry to try to come up with a new rate. Unlike Libor, which is based on banks' estimates of their general cost of non-collateralised borrowing, SOFR is based on actual interest rates in the U.S. Treasury repurchase (or repo) market. A repurchase agreement is a short-term secured loan collateralised by Treasury securities, with the seller agreeing to buy the securities back at a later date at a higher price.
Repos are a major source of short-term funding in the financial markets and a mechanism by which the Fed conducts its monetary policy. The repo market has an aggregate daily volume of more than US$800 billion. As a result, ARRC believes that a benchmark rate based on actual transactions in the repo market is a good alternative to Libor, which is subjective and susceptible to manipulation.
In addition, "Libor is based on relatively few transactions and relies heavily on expert judgement in determining the rate," the Securities Industry and Financial Markets Association (SIFMA) says. "The scarcity of underlying transactions makes Libor potentially unsustainable, as banks may eventually choose to stop submitting altogether."
More Reliable Than Libor
SOFR is more reliable because it tends to track the federal funds rate, the Fed's benchmark short-term rate that governs what banks charge each other for overnight loans. The New York Fed began publishing the daily SOFR on 3 April 2018. Andrew Bailey, the CEO of the U.K.'s Financial Conduct Authority (FCA), the regulatory agency that oversees Libor, has said a substitute must be in place by the end of 2021.
Slow Adoption Of SOFR
Despite the regulatory imperative to move away from Libor, some in the financial markets have been slow to embrace SOFR or any other alternative benchmark. In a speech at a conference sponsored by SIFMA in July 2019, New York Fed President John Williams urged the audience to embrace SOFR. At the same event, Bailey said Libor could become "unpredictable and problematic" if market participants continue to use it after 2021.
Nevertheless, large issuers have started to issue securities whose rates are tied to SOFR. In early August 2019, the U.S. Treasury said it was considering issuing floating-rate notes tied to the new benchmark. Earlier, a New York Fed working group endorsed using SOFR in pricing U.S. adjustable-rate mortgages. In 2018, the World Bank and Fannie Mae issued debt tied to SOFR, as have several large financial institutions.
The Secured Overnight Financing Rate (SOFR) is an interest rate benchmark favoured by the U.S. Federal Reserve as an alternative and eventual replacement for the London Interbank Offered Rate, or Libor, which is slated to be phased out in 2021. Libor has been used for decades to price floating-rate securities and bank loans but has grown in disfavour following a bank rate-rigging scandal during the financial crisis.
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Retrieved 12 Aug 2019 https://www.reuters.com/article/us-usa-bonds-sofr-explainer/what-is-sofr-the-new-u-s-libor-alternative-idUSKCN1HA0H1
Retrieved 12 Aug 2019 https://www.wsj.com/articles/fed-s-williams-calls-for-more-urgency-in-replacing-libor-11563195172
Retrieved 12 Aug 2019 https://www.wsj.com/articles/new-fed-rate-pulls-ahead-in-race-to-replace-libor-11565355989
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