What Is Secured Overnight Financing Rate?

The Secured Overnight Financing Rate, or SOFR, is a benchmark interest rate in global financial markets. It reflects the cost of borrowing cash overnight, providing a transparent and robust measure for various financial transactions. SOFR has gained prominence as a successor to previous benchmarks, influencing how interest rates are determined across a broad spectrum of financial products.

Defining Secured Overnight Financing Rate

The Secured Overnight Financing Rate (SOFR) measures the cost of borrowing cash overnight, where the borrowing is collateralized by U.S. Treasury securities. The “secured” aspect highlights that these transactions involve repurchase agreements, often called “repos,” where one party sells a security and agrees to repurchase it at a higher price the next day. This collateralization makes the borrowing low-risk for lenders, contributing to SOFR’s stability. The “overnight” component signifies that the rate reflects the cost of these short-term loans, which mature in one day.

SOFR is considered a broad and robust rate because it is based on a large volume of actual, observable transactions in the U.S. Treasury repurchase market. This market is highly liquid, with daily transaction volumes often exceeding $1 trillion, ensuring a reliable basis for the rate’s determination. Unlike benchmarks that rely on estimates, SOFR’s foundation in real transactions enhances its transparency and resistance to manipulation.

The rate is widely regarded as nearly risk-free due to the high quality of the collateral backing the transactions, specifically U.S. Treasury securities. This characteristic differentiates it from unsecured rates, which inherently include a component for credit risk. Because of this strong collateral, SOFR is less susceptible to fluctuations driven by changes in bank creditworthiness. Its design promotes a more stable and dependable benchmark for pricing financial instruments.

How SOFR is Determined

The Federal Reserve Bank of New York (FRBNY) calculates and publishes the Secured Overnight Financing Rate daily. This calculation is based on actual, executed transactions within the U.S. Treasury repurchase market. Data sources include tri-party repo data, General Collateral Finance (GCF) repo transaction data, and bilateral Treasury repo transactions cleared through the Fixed Income Clearing Corporation (FICC).

The FRBNY’s methodology involves calculating a volume-weighted median of these collected transactions. This approach gives greater influence to transactions with higher dollar volumes, ensuring the rate accurately reflects market activity. A volume-weighted median is also considered more resilient to erroneous data or outliers compared to a simple average. This robust calculation method enhances the reliability and integrity of the published rate.

The FRBNY publishes the SOFR rate each business day at approximately 8:00 a.m. Eastern Time. This consistent daily publication provides market participants with a timely and reliable benchmark. The transparency of its calculation, based on observable market data rather than subjective submissions, contributes to its acceptance as a dependable reference rate for financial contracts.

Where SOFR is Used

The Secured Overnight Financing Rate (SOFR) is extensively used across diverse financial products, serving as a transparent and robust benchmark for interest rate pricing. In the loan market, SOFR is a common reference rate for floating-rate loans. This includes corporate loans, syndicated loans, and adjustable-rate mortgages, where the interest rate adjusts periodically based on SOFR plus a specified spread. For instance, a loan might be structured with an interest rate of 3-month Term SOFR plus 2%, with the rate resetting quarterly.

SOFR also plays a significant role in the derivatives market, particularly in interest rate swaps. In these agreements, two parties exchange interest payments, with one payment often tied to a fixed rate and the other to a floating rate based on SOFR. Such derivatives are important tools for managing interest rate risk, allowing businesses and financial institutions to hedge against fluctuations in borrowing costs.

Furthermore, SOFR is incorporated into various bonds and other securities. Floating-rate notes, for example, have interest payments that adjust based on SOFR, providing investors with a yield that responds to current market conditions. Its application extends to securitizations and other financial contracts, where it provides a reliable underlying rate for complex financial structures. The broad adoption of SOFR across these products reflects its acceptance as a market standard for U.S. dollar-denominated financial instruments.

SOFR’s Role in Financial Markets

SOFR’s emergence is closely linked to the global effort to replace the London Interbank Offered Rate (LIBOR), a benchmark widely used for decades. LIBOR faced significant challenges, including manipulation scandals and a declining volume of underlying interbank transactions, which undermined its reliability. Regulators worldwide, including those in the U.S., determined that a more robust and transaction-based alternative was necessary to ensure financial stability and integrity. Most U.S. dollar LIBOR settings ceased publication after June 30, 2023.

In the United States, the Alternative Reference Rates Committee (ARRC), a group convened by the Federal Reserve Board and the Federal Reserve Bank of New York, identified SOFR as the preferred alternative reference rate for U.S. dollar-denominated contracts. SOFR’s foundation in actual, observable transactions in the Treasury repo market addressed many concerns associated with LIBOR’s reliance on estimated rates. This shift was a deliberate move towards greater transparency and market-based pricing.

The transition to SOFR has had a substantial impact on the financial industry, requiring widespread changes in systems, documentation, and risk management practices. It has promoted a more resilient financial ecosystem by providing a benchmark that is less susceptible to manipulation and more reflective of real market activity. The adoption of SOFR contributes to enhanced market integrity and supports the continued stability of the financial system.