The Right Rate? SOFR Vies to Become LIBOR's Replacement

With LIBOR's planned retirement in 2021, SOFR has emerged as the leading alternative for the key benchmark rate. This article is the second in our series of rates to know.

Lisa Isaacson, Managing Director - Product and Marketing

What is SOFR?  The Secured Overnight Financing Rate (SOFR) is part of the LIBOR reform introduced in 2018 by the U.S. Alternative Reference Rates Committee (ARRC) which defines its preferred rate, SOFR, as a "broad Treasuries repo refinancing rate."  For the U.S. rate market, SOFR is calculated using actual transactions in repurchase agreements collateralized with U.S. Treasuries and not with predictive transactions as with LIBOR. 

The New York Federal Reserve Bank (NY Fed) began officially publishing SOFR last April, well ahead of LIBOR's planned retirement at the end of 2021. The rate is published daily and provides historical views back to August 2014. Regulators hope that SOFR will eventually be adopted as the uniform published rate for U.S. dollar-backed loans and derivatives, reducing the market's overall dependency on LIBOR.

Key SOFR Features:

  • Overnight single rate calculation based on the previous day's trading

  • Calculated on all daily transactions in the Treasury repurchase market (repo), including tri-party repo cleared at BNY Mellon, General Collateral Finance (GCF) repo and delivery-vs.-payment trades through the Fixed Income Clearing Corporation

  • The published rate is equivalent to trades booked at the 50th percentile in a volume-weighted ordering of trades including various market segment participants, making it representative of general funding conditions

SOFR Limitations

  • Slow adoption among financial companies

  • Used as an overnight rate, with no longer terms being published

  • Secure funding level may move inversely to credit spreads during periods of financial stress

 

Why Adopt SOFR Now?

Although LIBOR remains the most widely used interest-rate benchmark, its reputation as a legitimate source was damaged during the financial crisis when inaccurate rate reporting helped make way for price manipulation at some banks. With the new legislative mandate resulting from LIBOR's inaccurate reporting, individual countries and their markets are being encouraged to come up with a rate source based on their own currency, debt and internal reporting.  For the United States, information feeding SOFR is coming from the NY Fed and regulated clearing sources, creating inherent accuracy in the SOFR rate that makes sense.

While SOFR stands beside LIBOR today and its adoption is not a regulatory mandate, ARRC has established a transition timeline for the rate and encourages market participants to revise LIBOR-based contracts to introduce fallback language incorporating another rate - ideally SOFR. In the bond space, we have started to see some new issue GSE paper utilizing the SOFR Index. In addition, certain corporate issuers are testing the waters and bringing deals to market based on SOFR. We expect to see more SOFR-linked bonds issued in the coming quarters as investors become more comfortable with the rate and LIBOR's retirement party nears.

Sources:

New York Fed, Alternative Reference Rates Committee Frequently Asked Questions, September 20, 2018

New York Fed, Statement Regarding the Publication of Historical Repo Rate Data, March 9, 2018

Reuters, "What is SOFR?  The new U.S. Libor alternative," April 3, 2018