Understanding the Secured Overnight Financing Rate (SOFR) is essential for anyone involved in mortgages, loans, or financial markets. SOFR has become the primary benchmark interest rate for U.S. dollar-denominated loans and derivatives, replacing the London Interbank Offered Rate (LIBOR) due to its transparency, reliability, and risk-free nature. In this article, we’ll explain what SOFR is, how it works, how it’s calculated, and why it matters for borrowers and investors.
What Is the Secured Overnight Financing Rate (SOFR)?
The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate that reflects the cost of borrowing cash overnight, collateralized by U.S. Treasury securities in the repurchase (repo) market. SOFR is considered nearly risk-free because these loans are backed by high-quality collateral, making it a robust measure of short-term borrowing costs. It is published daily by the Federal Reserve Bank of New York and is now the dominant reference rate for U.S. dollar loans, bonds, and derivatives.
Why Was SOFR Introduced? The Shift from LIBOR
SOFR was introduced to replace LIBOR, which had been the global benchmark for decades but became unreliable due to manipulation scandals and declining interbank lending volumes. Unlike LIBOR, which was based on estimates from panel banks, SOFR is derived from actual market transactions, making it more transparent and less susceptible to manipulation. The official transition from LIBOR to SOFR for U.S. dollar contracts was completed in June 2023.
How Is SOFR Calculated?
SOFR is calculated as a volume-weighted median of transaction-level data from three segments of the U.S. Treasury repo market:
Tri-party repo market: Transactions involving securities dealers, cash investors, and clearing banks.
General Collateral Finance (GCF) repo market: Collateralized agreements where the assets are not specified until the end of the trading day.
Bilateral repo market: Direct transactions between two parties cleared through the Fixed Income Clearing Corporation (FICC).
The Federal Reserve Bank of New York publishes SOFR each business day at approximately 8:00 a.m. ET, using data from the previous day’s transactions.
SOFR Term Structure: Overnight, Averages, and Term SOFR
Originally, SOFR was an overnight rate, but to meet the needs of borrowers and lenders who require forward-looking rates, the market developed SOFR averages and term SOFR:
SOFR Averages: Compounded averages over 30, 90, and 180 days, providing a smoother measure of borrowing costs over time.
Term SOFR: Forward-looking rates for 1, 3, 6, and 12 months, published by the CME Group, based on SOFR futures markets.
These versions of SOFR allow it to serve as a benchmark for a wide range of financial products, from overnight loans to longer-term adjustable-rate mortgages and derivatives.
SOFR vs. LIBOR: Key Differences
| Feature | SOFR | LIBOR |
|---|---|---|
| Collateralization | Secured by U.S. Treasurys | Unsecured interbank lending |
| Risk Profile | Nearly risk-free | Includes bank credit risk |
| Calculation | Actual overnight repo transactions | Bank-submitted estimates |
| Term Structure | Overnight, averages, and term SOFR | Multiple tenors (overnight to 12 months) |
| Transparency | Transaction-based, highly transparent | Subjective, prone to manipulation |
| Market Size | Trillions in daily transactions | Declining interbank volumes |
| Status | Active, primary USD benchmark | Phased out in June 2023 |
SOFR’s reliance on real transactions and collateralization by U.S. Treasurys makes it more stable and reliable than LIBOR, which was vulnerable to manipulation and reflected unsecured credit risk.
How Does SOFR Affect Mortgages and Loans?
SOFR is now the standard index for many adjustable-rate mortgages (ARMs), corporate loans, and derivatives in the U.S.. For ARMs, the interest rate adjusts periodically based on the current SOFR plus a margin set by the lender. For example, if your mortgage margin is 2% and SOFR is 5%, your new rate would be 7% at the next adjustment. Fixed-rate mortgages are not affected by SOFR, but many variable-rate financial products reference it.
Why Is SOFR Important for Borrowers and Investors?
Transparency: SOFR is based on actual transactions, providing a reliable benchmark for interest rates.
Stability: The large and liquid repo market ensures SOFR reflects true market conditions.
Reduced Risk: Because SOFR is nearly risk-free, it typically results in lower borrowing costs compared to unsecured benchmarks.
Widespread Adoption: SOFR is now the reference rate for trillions of dollars in loans, bonds, and derivatives worldwide.
Frequently Asked Questions About SOFR
Q: How often does SOFR change? A: SOFR is published every business day, reflecting the previous day’s overnight repo transactions.
Q: Can SOFR be manipulated? A: SOFR is difficult to manipulate because it is based on a large volume of actual transactions, unlike LIBOR, which relied on estimates.
Q: What is Term SOFR? A: Term SOFR provides forward-looking rates for specific periods (1, 3, 6, 12 months) and is used for products that require a rate set in advance, such as some loans and derivatives.
Q: Does SOFR affect my mortgage? A: If you have an adjustable-rate mortgage indexed to SOFR, your rate will adjust based on changes in SOFR at each reset period.
Conclusion
The Secured Overnight Financing Rate (SOFR) is a transparent, transaction-based, and nearly risk-free benchmark that has replaced LIBOR as the standard for U.S. dollar loans and derivatives. Its calculation from actual repo transactions and broad adoption across financial markets make it a reliable reference for borrowers and investors alike. As SOFR continues to shape interest rates for everything from mortgages to complex derivatives, understanding how it works is more important than ever.