Secured overnight financing rate (SOFR)
Secured overnight financing rate (SOFR) is referred to as a benchmark interest rate for dollar-denominated derivatives and loans. SOFR is an alternative to the London interbank offered rate (LIBOR) which was a long-standing benchmark rate used around the world. The Secured Overnight Financing Rate (SOFR) is an interest of borrowing cash overnight collateralized by Treasury securities. The daily SOFR is based on the average daily volume of transactions in the Treasury repurchase market where investors offer banks overnight loans backed by their bond assets.
On April 3, 2018, the Federal Reserve Bank of New York, in cooperation with the U.S. Office of Financial Research published The Secured Overnight Financing Rate (SOFR) for the first time.
SOFR is one of the Benchmark rates which are essential in the trading of derivatives, especially in interest-rate swaps. It is mainly used by corporations and other parties to manage interest-rate risk and to speculate on changes in borrowing costs. Interest rate swap is an interest rate derivative which involves the exchange of interest rates between two parties.
The Alternative Reference Rate Committee (ARRC) constituted by the Federal Reserve Bank of New York set the rate. SOFR is designed to coexist with Libor. However, the regulators think eventually institutions will transition from using Libor and move to SOFR. The Federal Reserve Bank of New York publishes SOFR rates daily.
In November 2019, the Federal Reserve Bank of New York outlined plans to produce SOFR averages along with a SOFR index. By publishing these averages on its website, which is expected to begin in the first half of 2020, the New York Fed will provide consistently calculated SOFR averages across various terms and an index to facilitate the calculation of averages over custom periods.
Secured overnight financing rate vs London interbank offered rate
SOFR is the US alternative for LIBOR, which was subject to unfair manipulation for several decades. Other regions around the world are also replacing LIBOR with their rates, such as ESTR for Europe and SONIA for the UK.
SOFR is purely based on actual transactional data in the American treasuries market. It is less prone to manipulation. But LIBOR is based on estimates provided by global banks and can be manipulated easily.
SOFR is only an overnight rate. LIBOR can be calculated in many different timeframes, from overnight to as long as 12 months.