What Is SOFR and What Is It Used For?
SOFR stands for the Secured Overnight Financing Rate, which is a benchmark interest rate that is used to calculate the cost of borrowing for financial transactions.
It is based on transactions in the repurchase agreement (repo) market, where banks and other financial institutions borrow or lend money overnight using US government securities as collateral.
SOFR is a replacement for the London Interbank Offered Rate (LIBOR), which was phased out by the end of 2021 due to concerns about its reliability and potential for manipulation.
SOFR is considered a more reliable benchmark rate because it is based on actual transactions rather than the estimates used to calculate LIBOR.
SOFR is used primarily in the United States for a variety of financial transactions, including derivatives, loans, and mortgages.
The Federal Reserve Bank of New York publishes SOFR on a daily basis, and it is widely accepted as a replacement for LIBOR by market participants.
SOFR is expected to play a key role in the global financial markets in the coming years as more countries move away from LIBOR and adopt new benchmark rates.
When Did SOFR Come Into Use?
SOFR, which stands for the Secured Overnight Financing Rate, came into use in April 2018.
It was developed by the Federal Reserve Bank of New York in response to concerns about the accuracy and reliability of the previous benchmark interest rate, the London Interbank Offered Rate (LIBOR).
SOFR is based on overnight loans collateralized by US Treasury securities, and is intended to provide a more transparent, reliable, and accurate measure of short-term borrowing costs for financial institutions.
It was adopted as a replacement for LIBOR.
SOFR vs. LIBOR
SOFR (Secured Overnight Financing Rate) and LIBOR (London Interbank Offered Rate) are both interest rate benchmarks used to determine the cost of borrowing money in financial markets.
However, there are some key differences between the two benchmarks.
LIBOR had been the most widely used benchmark for short-term interest rates since the 1980s. It is an average of the interest rates that major banks in London charge each other for short-term loans.
Manipulation of LIBOR
However, in 2017, concerns were raised about the reliability of LIBOR, as there were allegations of manipulation of the rate.
As a result, the UK Financial Conduct Authority (FCA) announced that it would no longer compel banks to submit LIBOR rates after the end of 2021, and that it would work with the industry to transition to alternative benchmarks.
SOFR based on overnight repo agreements
SOFR is an alternative benchmark to LIBOR that was introduced by the Federal Reserve Bank of New York in 2018.
It is based on overnight repurchase agreement transactions in the US Treasury market and is intended to be a more reliable and transparent benchmark than LIBOR.
SOFR is seen as a more representative rate because it is based on actual market transactions, rather than on banks’ estimates.
One of the main differences between SOFR and LIBOR is the way they are calculated.
LIBOR was calculated based on quotes submitted by a panel of banks, whereas SOFR is based on actual transactions in the repurchase agreement market.
This means that SOFR is considered to be more objective and transparent than LIBOR.
Differences in tenor
Another difference is the tenor of the rates.
LIBOR is available in a variety of tenors ranging from overnight to 12 months, while SOFR is only available as an overnight rate.
This means that banks will need to develop alternative benchmark rates for longer-term loans.
Overall, the transition from LIBOR to SOFR is a significant change for the financial industry.
While SOFR is seen as a more reliable and transparent benchmark, the transition will require significant effort and resources for market participants to adapt to the new rate.
SOFR Futures Explained
What Are SOFR Swap Rates?
SOFR is based on overnight repurchase agreements (repos) that are collateralized by U.S. Treasury securities.
SOFR reflects the cost of borrowing cash overnight, secured by Treasury collateral whereas LIBOR was based on unsecured interbank lending.
SOFR swap rates are used by market participants to hedge or speculate on interest rate movements.
A SOFR swap is an agreement between two parties to exchange a fixed interest rate for a variable interest rate based on SOFR.
The variable rate is typically the average of the daily SOFR rates over the swap’s term, and the fixed rate is negotiated between the two parties.
SOFR swap rates are closely watched by financial markets because they can signal the market’s expectations for future interest rate movements and may play an increasingly important role in the global financial system (espcially with LIBOR phased out).
Can You Trade SOFR Futures?
Yes, you can trade SOFR (Secured Overnight Financing Rate) futures through various brokers.
SOFR futures are listed on the Chicago Mercantile Exchange (CME), which is one of the world’s largest derivatives exchanges.
To trade SOFR futures, you first need to open an account with a futures broker that has access to the CME.
Examples of popular futures brokers that offer access to the CME include TD Ameritrade, Interactive Brokers, E*TRADE, and Charles Schwab.
Once you have opened an account with a futures broker, you can place an order to buy or sell SOFR futures.
The CME offers several SOFR futures contracts, including three-month and one-month SOFR futures.
The contract specifications for each SOFR futures contract are available on the CME’s website, and include information such as the contract size, tick size, and trading hours.
As always, before trading SOFR futures, it’s important to understand the potential risks and rewards involved and to have a well-developed trading strategy in place.