sofr

Key Takeaways

The Secured Overnight Financing Rate (SOFR) is an important benchmark for pricing loans, derivatives, and other financial instruments.

As the replacement for the London Interbank Offered Rate (LIBOR), SOFR offers a more transparent alternative that reflects the cost of borrowing in the US financial system.

Following LIBOR’s vulnerabilities, which were exposed during the 2008 financial crisis, SOFR has become the preferred benchmark for US dollar-based financial contracts.

Traded on the Chicago Mercantile Exchange (CME), SOFR futures let investors hedge or speculate on future rates.

What Is SOFR?

SOFR stands for Secured Overnight Financing Rate. It’s basically a number that shows how much it costs to borrow money overnight when the loan is backed by safe US Treasury securities. Think of it like a daily snapshot of borrowing costs in a huge market where banks and other big players swap cash and Treasuries.

Administered by the Federal Reserve Bank of New York in collaboration with the US Treasury’s Office of Financial Research (OFR), SOFR is calculated using actual transactions in the repurchase agreement (repo) market, where institutions borrow and lend cash secured against Treasuries.

How Does SOFR Work?

Unlike LIBOR, which was based on what banks guessed they’d charge each other, SOFR uses real deals from the “repo” market (short for repurchase agreements). 

Published daily at 8 a.m. ET, SOFR reflects data from the prior business day, providing a reliable snapshot of overnight borrowing costs. Its transaction-based nature and the link to a market with over $1 trillion in daily volume made SOFR a more trustworthy benchmark.

By 2023, LIBOR was mostly phased out, and SOFR stepped up as the go-to rate for all sorts of financial stuff, from business loans to sophisticated Wall Street trades.

Where do the numbers come from?

SOFR is built on actual trades in the repo market, where people borrow cash and promise to pay it back the next day, using Treasuries as collateral. The data comes from three main types of deals:

Third-party repos: An intermediary, like a bank, handles the cash and collateral swap.

General Collateral Financing (GCF) repos: These go through a clearinghouse called the Fixed Income Clearing Corporation (FICC).

Bilateral repos: Direct deals between two parties, also cleared by FICC.

The New York Fed takes all these trades, looks at the interest rates, and picks the middle value (called a volume-weighted median) to set SOFR. With over $1 trillion in daily trades, this methodology reflects the tendency of borrowing costs and provides a robust rate that is less susceptible to outliers or market distortions. 

In addition, they also share extra details, like how much money was traded and where the rates fell (like the top and bottom 10%). You can check all this on their website, along with data from previous years.

SOFR Averages and Index

Since SOFR is an overnight rate, it doesn’t work very well for longer-term stuff like loans or bonds. That’s where SOFR Averages and the SOFR Index come in. The averages (for 30, 90, or 180 days) add up daily SOFR rates to give a smoother number for things like mortgages. The SOFR Index, which started in 2018, tracks how SOFR compounds over time, making it easier to figure out payments for complex deals.

The SOFR Averages and the SOFR Index are tools that facilitate the use of SOFR in applications beyond overnight lending, such as adjustable-rate mortgages and corporate debt.

Why SOFR Matters in Finance

Switching from LIBOR to SOFR was a big deal. It took a lot of work to update contracts and systems, but SOFR’s clear approach and alignment with global standards have solidified its position as a trusted benchmark.

SOFR serves as the backbone for a wide range of financial products, including:

Loans: Think business loans or mortgages where the interest rate changes over time.

Derivatives: Fancy contracts like swaps or futures that speculate on interest rates.

Bonds and securities: Things like mortgage-backed securities often use SOFR as a benchmark.

Everyday stuff: Even some adjustable-rate mortgages or student loans use SOFR.

Advantages of SOFR

No fudging: It’s based on real trades, not guesses, so it’s hard to fake.

Stability: With tons of trades every day, it stays steady even when markets get wild.

Safe: Backed by Treasuries, it’s about as low-risk as you can get.

Broad support: Backed by the Alternative Reference Rates Committee (ARRC) and aligned with international standards.

Challenges of SOFR

Overnight nature: It’s just an overnight rate, so you need to do some math for longer deals.

Transition costs: Shifting from LIBOR involved updating contracts and systems, a complex process for market participants.

Volatility: It can spike when markets are stressed, but it’s still safer than other rates.

SOFR Futures

SOFR futures are derivative contracts that allow investors to hedge or speculate on future changes in the SOFR rate. Traded primarily on the Chicago Mercantile Exchange (CME), these futures have become a handy tool for managing interest rate risk or trying to make a profit.

What are SOFR futures?

SOFR futures are standardized contracts based on the expected average SOFR rate over a specific period. In other words, they let you lock in or speculate on what the SOFR rate will be in the future. The two primary types are:

1-Month SOFR Futures: Based on the average SOFR over a month, with a value of $25 per basis point (a tiny rate change).

3-Month SOFR Futures: Based on a three-month average, worth $12.50 per basis point.

These contracts are cash-settled, meaning you don’t swap actual money or Treasuries at the end. They are settled based on the SOFR rate during the contract period, as published by the New York Fed.

How do they work?

Imagine you’re a bank worried that SOFR might shoot up, making your loans more expensive. You could buy SOFR futures to lock in today’s rate, so you’re protected if rates climb. Or, if you’re an investor who thinks rates will drop, you might sell futures to cash in when they do.

The futures are priced as 100 minus the expected SOFR rate, and their value shifts as people’s predictions change. The CME handles daily updates to keep everything fair, so you’re not stuck if the market moves against you.

Why use SOFR futures?

Risk management: Financial institutions use SOFR futures to hedge exposure to SOFR-based loans, swaps, or other instruments.

Market insight: Futures prices reflect market expectations of future SOFR rates, providing valuable information for monetary policy analysis.

Term rate development: SOFR futures data contribute to the creation of forward-looking SOFR term rates, which are used in some LIBOR-replacement contracts.

Comparing SOFR to Other Benchmarks

SOFR isn’t the only rate out there, so let’s see how it compares:

Vs. LIBOR: SOFR uses real trades and is very safe, while LIBOR was based on estimates and is riskier. LIBOR had rates for months ahead; SOFR needs some math for that.

Vs. Federal Funds Rate: SOFR covers more repo deals, while the federal funds rate is about unsecured bank lending. SOFR is broader and safer.

Vs. Global Rates: Like the Euro Short-Term Rate (€STR) or the Sterling Overnight Index Average (SONIA), SOFR is a risk-free rate, but it is unique in its reliance on the US repo market.

These differences make SOFR perfect for dollar-based deals, especially since it’s tied to secure Treasuries.

Does SOFR Impact Crypto Markets?

SOFR doesn’t directly move the needle in crypto markets, but it can still give some insights into market sentiment. As a benchmark tied to overnight borrowing costs, SOFR reflects what’s happening with interest rates and liquidity in traditional finance. 

When SOFR climbs, it often means borrowing is getting more expensive, which can make investors think twice about riskier assets like cryptocurrencies. For example, if the Federal Reserve tightens policy and SOFR spikes, crypto prices might dip as people shift to safer assets like bonds.

On the flip side, a low SOFR may relate to higher demand for speculative assets like crypto. SOFR futures, traded on the CME, also play a role by showing what big players expect from future rates, which could indirectly affect broader market sentiment and crypto trading.

Closing Thoughts

SOFR, the Secured Overnight Financing Rate, is a game-changer in finance. It’s a transparent, reliable number that replaced LIBOR, guiding everything from loans to derivatives. SOFR futures add a layer of flexibility, letting people hedge risks or speculate on where rates are going. With its roots in real trades and a safety net of Treasuries, SOFT will likely be around for a long time.

For those seeking to explore SOFR further, resources from the New York Fed and CME offer detailed data and market insights.

Further Reading

What Is a Yield Curve and How to Use It? 

What Are Bonds and How Do They Work?

Interest Rates Explained

The 2008 Financial Crisis Explained

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