SOFR: what is it and how does it work?
Numbers and rates play a crucial role in driving economic decisions, but where do these rates come from and how are they calculated on a daily basis? Our economy and the way it’s managed has evolved throughout the years and so has the way we measure it. Secured Overnight Financing Rate (SOFR) is a primary and contemporary example of how these economic benchmarks are optimized.
What is SOFR (Secured Overnight Financing Rate)?
SOFR is used by financial institutions to help measure the cost of borrowing cash overnight, backed by Treasury securities. In simpler terms, it’s a benchmark used to set interest rates for other businesses and borrowers.
The “overnight financing” aspect refers to how SOFR sets rates for lenders — primarily based on the rates that large financial institutions pay each other for overnight loans. The “secured” part represents the collateral that backs the loans, which is meant to add an additional layer of safety and stability in the rate.
LIBOR vs. SOFR
To understand SOFR, it’s helpful to begin learning about its roots. Before there was SOFR, there was LIBOR. LIBOR stands for the London Interbank Offered Rate and was once the go-to benchmark for interest rates until the financial crisis of 2008 and 2009, when people were exposed to LIBOR’s significant vulnerability to market manipulation.
This is what led to the development of SOFR, an alternative way of calculating benchmarks for interest rates. The shift from LIBOR to SOFR was both an effort to help level out market fluctuations, and more importantly, mitigate the concerns associated with LIBOR. SOFR was a significant step toward creating a more reliable and stable environment for interest rates.
How does SOFR work?
Major financial institutions borrow and lend each other money using Treasury bond repurchase agreements, also known as “repos.” These are short-term secured loans where one party sells securities to another party, and the selling party agrees to repurchase those securities at a higher price. The difference between the initial price and the repurchase price ends up being the interest paid on the loan, or, the “repo rate.”
SOFR helps aggregate and weigh the averages of the rates charged during the repo transactions from the night before.
How is SOFR calculated?
SOFR is calculated by:
- Collecting repo data.
- Weighing the averages.
- Publishing the calculated rate.
The final calculated rate is published on the morning of the next business day and represents the cost of borrowing funds secured by the U.S. Treasury securities for that overnight period.
SOFR and mortgages
Interest rates and APRs are particularly relevant to current or prospective homeowners. SOFR impacts most loan rates through its expression of how interest rates look overall. So, if you’re curious about mortgage rates, SOFR will likely serve as a benchmark indicator that represents whether mortgage rates are headed in an upward or downward direction. From a high level, inflation and the overall state of the economy have the biggest impact on mortgage interest rates.
In summary
SOFR, the Secured Overnight Financing Rate, has emerged as a pivotal player in the financial world by reshaping the landscape of how we measure benchmark interest rates. It began as a response to its predecessor LIBOR, which proved controversial with issues related to market manipulation. SOFR is a daily updated rate that uses Treasury securities as collateral. Although SOFR isn’t the sole determinant of mortgage interest rates, it impacts the overall financial market and new loans generated.
SOFR FAQs
How often does SOFR change?
SOFR is calculated and published daily. Depending on activity from the day before, SOFR can change every day. However, the severity of those margins will depend on the overall state of the economy.
Is SOFR better than LIBOR?
SOFR was made with the goal of being a more transparent, trustworthy and reliable way to benchmark and communicate interest rates.
Is SOFR replacing LIBOR?
Yes, there has been a slow transition from LIBOR to SOFR since 2020. However, in January 2022, SOFR officially replaced LIBOR when generating new loans in the United States.
