Federal Reserve in 2018 as an alternative to the London Interbank Offered Rate (LIBOR). SOFR was created in response to the Libor scandal, which occurred from 2005 to 2009 and resulted in several banks being heavily fined for manipulating Libor. The emergence of SOFR has been very well received by market participants, who view it as more reliable than LIBOR due to its greater reliance on actual trading activity.
In order to understand the significance of SOFR, it is important to understand the structure of the U.S. financial system. The Federal Reserve System is the central banking organization of the United States and consists of twelve regional reserve banks. The FOMC (Federal Open Market Committee) is an arm of the Federal Reserve System and is responsible for setting and overseeing monetary policy. The FOMC works in tandem with the Financial Services Regulatory Authority (FRB) to ensure that the U.S. financial system remains safe and sound.
SOFR is a distinct type of interest rate called a “risk-free” rate. This means that it is not expected to come with any market risk, which is why it is viewed as more reliable than LIBOR. Since SOFR’s establishment, it has become the benchmark in U.S. dollar financial transactions and has replaced LIBOR in many markets. The US Dollar London Interbank Offered Rate (USD LIBOR) is also being gradually replaced by a new benchmark rate, the US Treasury repo rate.
Unlike LIBOR, SOFR is based on actual overnight repurchase agreements (repos) in the U.S. Treasury market. Repos are short-term agreements in which one party agrees to buy securities from another party at predetermined times and prices. When a repo is executed, the lender receives collateral from the borrower, such as U.S. Treasury bonds or other government securities. The borrowing party pays an agreed-upon interest rate, which determines the rate of return for the lender.
The SOFR is calculated from a number of sources, including the U.S. triparty repo market. This repo market includes transactions between primary dealers (banks, insurance companies, and other financial institutions that are authorized to trade directly with the Federal Reserve) and their customers. The data is collected from only the largest money markets institutions, which include Bank of America, JPMorgan Chase, Goldman Sachs, and Bank of New York Mellon. By collecting data from these sources, the Federal Reserve is able to calculate a daily average of overnight repo rates. This average is then used to calculate the SOFR.
The SOFR can be affected by changes in the economy, such as when the Federal Reserve raises or lowers interest rates. When this happens, interest rates on repos also change, and this will in turn affect the SOFR. In addition to these factors, the SOFR can also be affected by other factors, such as the amount of liquidity in the U.S. financial system, the amount of outstanding repos, and the amount of supply of U.S. Treasury securities.
Overall, SOFR is an important benchmark rate that serves as an alternative to LIBOR. It is viewed as more reliable because it is based on actual trading activity and is calculated using data from large money markets institutions. It is also less susceptible to manipulation than LIBOR, which makes it a better, more secure option for financial transactions. The Federal Reserve is continuing to monitor the development of SOFR as well as its impact on the financial markets and is likely to make adjustments as it deems necessary.
The Secured Overnight Financing Rate (SOFR) was established by the U.S. Federal Reserve in 2018 as an alternative to the London Interbank Offered Rate (LIBOR) due to the Libor scandal from 2005 to 2009. SOFR is a “risk-free” rate since it is not expected to come with any market risk, and it has become the benchmark for U.S. dollar financial transactions, replacing LIBOR in many markets. It is calculated using data from the U.S. triparty repo market, which consists of primary dealers (banks, insurance companies, and other financial institutions authorized to trade with the Federal Reserve) and their customers. SOFR is based on overnight repurchase agreements (repos), which are short-term agreements in which one party agrees to buy securities from another party at predetermined times and prices. In addition to changes in the Federal Reserves' interest rates, SOFR can be affected by other factors, such as the amount of liquidity in the U.S. financial system and the amount of outstanding repos and U.S. Treasury securities. The Federal Reserve is monitoring the development of SOFR to ensure it remains a secure option for financial transactions.
This article was contributed on Nov 28, 2023
