SOFR: A Guide to Secured Overnight Financing Rate

Secured Overnight Financing Rate (SOFR) is a notable benchmark when it comes to pricing derivatives, loans, and other such financial instruments. It has taken the place of the London Interbank Offered Rate (LIBOR) by providing a relatively transaction-based and transparent alternative. This article explains SOFR, its use cases, comparison with the rest of benchmarks, and impact on the crypto markets in general.

Introduction to SOFR

Secured Overnight Financing Rate (SOFR) operates as a number that points out the cost of borrowing money overnight while the loan is supported by safe United States Treasury securities. Hence, it assimilates an everyday snapshot of the total borrowing charges in a wider market where banking institutions and other large players exchange Treasuries and cash. The Federal Reserve Bank of New York administers SOFR in partnership with the Office of Financial Research (OFR) at the U.S. Treasury. It is reportedly calculated by utilizing actual transfers in the repurchase (repo) market. There, institutions lend and borrow cash that is secured against U.S. Treasuries.

Working of SOFR

SOFR is dissimilar to London Interbank Offered Rate (LIBOR), which took into account what the banking institutions estimated to have charged each other. In this respect, SOFR utilizes real deals taking place in the repo market. SOFR is published every day at 8 a.m. ET, reflecting data from the previous business day. It provides a dependable overview of the overall overnight borrowing costs. The transfer-based nature of SOFR and the association with a market with more than $1T in daily volume turn it into a relatively trustworthy benchmark.

By the year 2023, LIBOR was almost phased out, while SOFR took a considerable position in the market. It became a go-to rate catering to all financial stuff, including business loans as well as refined Wall Street trades. SOFR is based on the trades that actually take place in the repo market. In that market, people carry out cash borrowing while promising to repay the value the next day by using Treasuries in the form of collateral.

The data reportedly comes from 3 key deal types, including 3rd-party repos, bilateral repos, and general collateral financing repos. Specifically, the 3rd-party repos take into account an intermediary, such as bank, handling the collateral and cash swap. Additionally, bilateral repos are the direct deals that occur between 2 parties. They are also cleared by the Fixed Income Clearing Corporation (FICC). Apart from that, General Collateral Financing (GCF) repos also go through the FICC clearinghouse.

In this respect, the New York Fed keeps in view all the respective rates, focuses on the interest rates, and selects the middle value for SOFR. Along with that, they also provide more details such as the complete amount of traded funds and the decline of the rates in percentage, in addition to the data from past years. While SOFR efficiently provides overnight rate, the benchmark has a limitation when it comes to evaluating longer-term overview of the stuff like bonds or loans. For this purpose, the SOFR Index and SOFR Averages play a crucial role.

Specifically, the averages for thirty, ninety, or even one hundred and eighty days add regular SOFR rates, offering a smoother number in the case of mortgages. Moreover, SOFR Index, which was initiated back in the year 2018, effectively tracks how SOFR evolves. It provides ease in figuring out payments when it comes to complex deals.

Use Cases of SOFR in Finance

The clear approach of SOFR and its alignment with the worldwide standards have fortified its status as a reliable benchmark. Thus, SOFR operates as the key benchmark for diverse financial products. They take into account derivatives, loans, securities and bonds, mortgages, and more. Particularly, business mortgages or loans witness changes in interest rates over time. Similarly, futures, swaps, or other such fancy contracts also take into account speculation on interest rates. Just like that, mortgage-backed securities also utilize SOFR. In the same vein, a few student loans or adjustable-rate mortgages also use SOFR.

SOFR in Comparison with Other Benchmarks

Apart from SOFR, there are also some other benchmarks available in the financial sphere, including LIBOR, federal funds rate, and worldwide rates. In comparison with LIBOR, SOFR utilizes actual trades while providing substantial safety. However, LIBOR deals with estimates, appearing riskier. Additionally, federal funds rate, SOFR takes into account a wide range of repo deals. Nonetheless, the federal funds rate focuses on unsecured lending from banks. When compared with worldwide rates, SOFR delivers a risk-free rate and is unique while being reliant on the United States repo market, in contrast to the worldwide rates like Sterling Overnight Index Average (SONIA) or the Euro Short-Term Rate (€STR).

SOFR’s Impact on Crypto Markets

While SOFR has no direct influence on the crypto markets, it has the potential to provide insights into the general market sentiment. Working as a benchmark linked to overnight borrowing charges, SOFR highlights what is going on with liquidity and interest rates in conventional finance. A spike in SOFR often suggests that borrowing is becoming relatively expensive, pushing investors to be more careful toward riskier assets such as cryptocurrencies. On the other hand, as SOFR declines, it points toward the increased demand for crypto and other such speculative assets.

Conclusion

In line with the above-mentioned overview of the Secured Overnight Financing Rate (SOFR), it is a game-changing benchmark in the financial sector. It is a reliable and transparent number that took LIBOR’s place to let users hedge risks and speculate on the future direction of rates. This indicates that SOFR will potentially be an effective benchmark for a notable period.