The Secured Overnight Financing Rate (SOFR) is the benchmark interest rate most likely replacing LIBOR in the United States by the end of 2021. More than $80 trillion in loans have already switched over to SOFR, which is based on the cost of overnight borrowing that banks pay when they complete repos, or U.S. Treasury repurchase agreements.
LIBOR, the London Interbank Offered Rate, used to be a commonly used system for setting commercial and consumer loan interest rates. However, after playing a role in several manipulation scandals as well as the financial crisis and the Great Recession, there has been a global shift away from LIBOR.
There are some important differences between LIBOR and SOFR to know about, some of which may affect consumers and investors. Read on to learn more about the LIBOR replacement, SOFR.
What Is the Secured Overnight Financing Rate (SOFR)?
Financial institutions use SOFR as a tool for pricing corporate and consumer loans. SOFR sets rates based on the rates that financial institutions pay one another for overnight loans or repos, hence the name overnight financing. The SOFR rate is published daily by the Federal Reserve Bank of New York.
SOFR is a popular benchmark because it is risk-free, robust, and transparent. It is based on more than $1 trillion in cleared marketplace transactions, whereas LIBOR is only based on hypothetical short-term loan rates. This has historically made LIBOR less reliable and more vulnerable to insider manipulation.
A benchmark rate like SOFR is especially important in derivatives trading, where interest-rate swaps are used by corporations to manage the risk of interest rates and for speculation on borrowing. Traders may exchange fixed-rate payments and adjustable-rate payments. The rates are all based on a benchmark such as LIBOR or SOFR, as well as the party’s credit rating and other factors.
How Does the SOFR Work?
When large financial institutions lend money to one another in order to adhere to reserve and liquidity requirements, they do so through the Treasury repurchase market using Treasury bond repurchase agreements, also known as repos. Using repo agreements, Treasurys are used as collateral and banks are able to make overnight loans.
SOFR is made up of the weighted averages of the interest rates used in real, finalized repo transactions.
Current SOFR Rates
Current SOFR rates can be found through the Federal Reserve Bank of New York.
The current 1-month and 3-month SOFR averages are 0.05%.
The History of SOFR
As mentioned above, the adoption of SOFR is a result of the need to phase out LIBOR, which was previously used for determining interest rates for borrowing money and the costs of complex transactions that may involve mortgages, derivatives, credit default swaps, and asset-backed securities.
Financial institutions, banks, and lenders rely on particular indexes to determine interest rates. Before the 1980s, there wasn’t one particular index that was used internationally. However, during the 1980s, increased complexity in the market resulted in the need for more standardized use of a benchmark tool for determining adjustable rates.
The international financial industry adopted LIBOR as the standard because it was viewed as a trusted, accurate and reliable index. Other indexes were still used, but the majority of institutions used LIBOR. LIBOR rates were the basis for about $300 trillion in assets around the world.
Fast forward to around 2008, and certain large financial institutions were manipulating interest rates illegally in order to increase their profits. This was possible in part because of the use of LIBOR, since it’s based on hypothetical rates. Manipulation of rates was one factor that led to the financial crisis.
Once that manipulation was discovered, there was a global demand for a new rate benchmark and a call to end the use of LIBOR. As a result of the crisis, banking regulations led to less borrowing and a lessening of trading activity. Less trading made LIBOR even less reliable.
In 2017, the Federal Reserve formed a group of large financial institutions known as the Alternative Reference Rate Committee (ARRC) to work on finding an alternative to LIBOR. They ultimately chose SOFR.
While SOFR is designed to work in conjunction with LIBOR, it ultimately may replace it completely. Now that fewer and fewer loans are using LIBOR and backing the rate, there is even less reason to use it.
It’s expected that LIBOR will be fully phased out by the end of 2021.
How SOFR Is Different From LIBOR
There are some key differences between SOFR and LIBOR, which also in part explain why the shift toward using SOFR in recent years. Some of the main differences are:
• SOFR is based on completed transactions whereas LIBOR is based on quotes and hypothetical rates. This makes LIBOR more vulnerable to manipulation because it’s based on hypotheticals, which may not be from real financial institutions.
• Lending based on LIBOR doesn’t use collateral, making it unsecured. Loans using LIBOR include a premium due to credit risk. SOFR, on the other hand, is secured as it is based on transactions backed with Treasurys. Therefore, there is no premium included in the interest rates.
• With LIBOR, banks know ahead of time what the borrowing rate will be. With SOFR, they don’t know precisely what it will be until the loan term ends.
• SOFR must be updated twice a year, while LIBOR is updated just once a year.
• SOFR is a daily (overnight) rate whereas LIBOR has seven variable rates.
How SOFR Could Affect You
There has been some concern that shifting away from LIBOR will cause great market disruption. However, the shift has been designed to be a slow transition, so the risk of that is pretty low. Still, the transition may result in short-term trading volatility for derivatives traders.
If you already have a mortgage, the transition to SOFR could affect you, though you likely won’t notice the change. Those with a 5-, 7-, or 10-year adjustable-rate mortgage with a fully indexed interest rate based on LIBOR may see a small rate change, but it is unlikely to be very significant. If you are entering into a loan, SOFR rates are already being used.
Since SOFR is updated more frequently, this could result in a change in the cost of borrowing cash. To avoid this uncertainty, you could consider taking out a fixed-rate loan for student loan refinancing.
The SOFR index is meant to be more reliable and less risky though, so the transition should be a positive thing for you if you are a borrower worried about student loan interest rates, for instance, or if you are considering taking out a mortgage.
Now that you know more about the transition to SOFR from LIBOR, you can likely rest easy. The effects of the shift to SOFR should be minimal, and they could even turn out to be a good thing if, for instance, you’re considering taking out student loans.
SoFi® uses SOFR for its student loan interest rates, and you can apply and get approved for a private student loan or refinance right from your phone.
Photo credit: iStock/Nicholas Ahonen
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