What Does the SOFR Rate Mean for Your Finances?

The Secured Overnight Financing Rate, or SOFR, is a benchmark interest rate. It measures the cost of borrowing cash overnight, playing a role in various financial transactions. Understanding SOFR is important for consumers and businesses, as it influences financial products and serves as a reference rate in the United States.

How SOFR is Determined

SOFR is calculated based on transactions in the overnight repurchase agreement (repo) market, where cash is borrowed overnight collateralized by U.S. Treasury securities, making SOFR a secured rate.

The Federal Reserve Bank of New York (FRBNY) calculates and publishes SOFR daily. This calculation is derived from actual transactions across three repo market segments: tri-party repo data, General Collateral Finance (GCF) repurchase agreements, and bilateral Treasury repo transactions cleared through FICC’s DVP Service. The resulting rate is a volume-weighted median of these transactions, providing a measure of the cost of overnight cash borrowing.

SOFR’s Role in Financial Transactions

SOFR serves as a benchmark for pricing and valuing financial instruments. It is used across financial markets, including corporate loans, floating-rate bonds, and derivatives. Floating-rate loans, which adjust periodically, often reference SOFR.

Financial products such as asset-backed securities, mortgages, and some consumer loans use SOFR as their reference rate. Derivatives, including interest rate swaps, use SOFR to manage interest rate risk and hedge against fluctuations in borrowing costs. Its adoption across diverse products establishes its utility as an indicator for short-term borrowing costs.

The Transition from LIBOR to SOFR

The move to SOFR stems from the phasing out of the London Interbank Offered Rate (LIBOR). LIBOR faced challenges, including manipulation scandals and a lack of actual transactions, which undermined its reliability. Regulators globally, including those in the U.S., sought a robust and transparent alternative.

SOFR emerged as the replacement for U.S. dollar LIBOR due to its foundation in actual, observable transactions within a liquid market. The U.S. financial authorities, through the Alternative Reference Rates Committee (ARRC), recommended SOFR as the alternative to LIBOR. This shift, largely concluded by June 30, 2023, aimed to provide a stable and less susceptible benchmark. SOFR’s transaction-based nature and its collateralization by U.S. Treasury securities offer transparency and reduced manipulation risk compared to LIBOR’s reliance on estimated rates.

Different Forms of SOFR

While SOFR is an overnight rate, its application in financial products has different forms. Daily SOFR is the rate for a single day’s borrowing. For longer-term financial products, compounded SOFR rates are used.

Compounded SOFR averages daily SOFR rates over a specific period (e.g., 30, 90, or 180 days) to smooth fluctuations and reflect interest accrual. “Term SOFR” provides a forward-looking rate for various maturities (e.g., one, three, six, or twelve months). Term SOFR is derived from SOFR futures and derivatives markets, offering a rate known at the beginning of an interest period, similar to LIBOR.