SOFR: A comprehensive guide
How SOFR, the benchmark rate chosen by the ARRC to replace USD LIBOR, works and what drives its movements
Why was SOFR created?
In July 2017, the UK Financial Conduct Authority (FCA) announced that it would no longer require banks to submit cost of funds quotes in support of calculating LIBOR, calling into question LIBOR’s viability and availability past 2021. In June 2017, the Alternative Reference Rates Committee (ARRC), a private-public partnership convened by the Federal Reserve Board of Governors (the Fed) and the Federal Reserve Bank of New York (the New York Fed), identified the Secured Overnight Financing Rate (SOFR) as its preferred replacement for USD LIBOR.
What is SOFR?
Unlike USD LIBOR, SOFR is a fully transaction-based rate, and therefore, less susceptible to market manipulation and more attractive to regulators. SOFR measures of the cost of borrowing cash overnight collateralized by Treasury securities. There are approximately $900 billion of actual market transactions supporting the daily calculation of SOFR. Conversely, USD LIBOR relies primarily on expert judgment of the LIBOR panel’s submissions to calculate this rate. The most actively traded USD LIBOR tenor is three months, and less than $1 billion of transactions typically support the calculation of this rate each business day. There is a much more robust market supporting the calculation of SOFR.
How is SOFR calculated?
The New York Fed calculates SOFR by taking the volume-weighted median (50th percentile) of transactions in three markets for repurchase (repo) agreements collateralized by U.S. Treasury securities:
- Tri-party repo data
- General Collateral Finance (GCF) repurchase agreements transaction data
- Bilateral Treasury repo transactions cleared through FICC’s DVP Service (Fixed Income Clearing Corporation’s Delivery vs. Payment Service).
The New York Fed publishes SOFR at 8 a.m. EST each day. In contrast to the different term LIBORs (i.e., 1-month LIBOR, 3-month LIBOR, etc.), it is an overnight, fully secured rate.
Why did the ARRC identify SOFR, as compared with other alternatives, as the replacement for USD LIBOR?
The ARRC’s primary stated criteria in choosing a replacement rate for USD LIBOR included liquidity and robustness of underlying markets, as well as not restricting the Fed’s future monetary policy choices. Based on these and other criteria, the ARRC identified SOFR, where disinterested third-party clearinghouses report the terms of the large volume of transactions underlying the rate, as compared with determining LIBOR, which, as a practical matter, is based on panel banks’ submitting borrowing costs based on expert judgment because there is so little unsecured bank-to-bank lending post-Great Financial Crisis. In identifying SOFR, the ARRC ruled out the use of certain other rates, including the Effective Federal Funds Rate, citing market size and the potential to constrain monetary policy, as well as Treasury bill or bond rates, citing concerns around certain technical factors and how they respond to safe haven demands in periods of stress.
What are the repo markets that underlie SOFR?
Repo markets, broadly, are those in which banks and other large financial institutions and corporates borrow or lend cash secured by liquid securities, often U.S. Treasuries, for short periods of time, typically overnight. In the tri-party repo market, a clearing bank sits between broker/dealers that borrow from cash investors (e.g., money market funds, mutual funds, et al.). The GCF repo market is a tri-party repo market used only between dealers who borrow cash against general collateral (i.e., securities that are not specified until the end of the trading day). In the DVP repo market, asset managers and other investors (e.g., REITs) borrow specific securities from broker-dealers and securities lenders on a bilateral or cleared basis.
What drives supply and demand in the repo markets that underlie SOFR?
Some of the factors that impact supply and demand in the Treasury repo market are:
- Fed Funds Target Rate: The lowest U.S. rate is the rate paid by the Fed to investors in certain repo transactions. This rate is the lower bound of the Fed Funds target range; increases in the Fed Funds target range will drive an increase in repo rates. This is the most significant driver of SOFR and sets a floor below which SOFR is unlikely to fall.
- Reduced bank balance sheet availability: Bank balance sheets typically experience greater pressure at quarter end and year end; these liquidity and capital needs are often funded through repo, which increases repo rates. This factor drives the tendency of SOFR to spike at quarter- and year-end.
- MMF sensitivity to T-Bill Issuance: Money market funds (MMF) account for about half of the repo market activity from which SOFR is calculated. MMFs can typically invest in repo, Treasury Bills, and discount notes. An increase in T-Bill issuance will push yields higher, causing MMFs to substitute bills for repo assets, driving an increase in repo rates.
- Government MMF balance increase: Higher balances in government MMFs result in more cash available for repo, which lowers repo rates.
- Flight to safety/quality: Periods of market stress in “risk assets” including equities, corporate bonds, real estate, et. al. increase demand for Treasury repo collateral, pushing repo rates down.
Isn’t a market-driven rate inherently volatile?
The market dynamics of the Treasury repo market make daily spot SOFR more volatile than spot USD LIBOR. To address this, the ARRC, the International Swaps and Derivatives Association (ISDA), and other market participants have recommended a variety of options, all of which reduce the volatility otherwise associated with a daily rate, for calculating SOFR over a given interest period.
- Simple daily SOFR in arrears: simple average of daily SOFR during an interest period, determined at the end of the period
- SOFR compounded in arrears: compounded daily SOFR during an interest period, determined at the end of the period
- SOFR compounded in advance: compounded rate based on daily SOFR during the previous 30, 60, or 90 days, determined at the beginning of an interest period
Why did the CFTC’s Market Risk Advisory Committee (MRAC) develop the SOFR First initiative?
SOFR First has four phases with phase one, involving USD linear swaps. The MRAC has supported the SOFR First initiative, which calls for interdealer brokers to transition from trading LIBOR linear interest rate swaps to SOFR linear swaps beginning July 26, 2021. It is expected that this initiative will increase SOFR liquidity ahead of the end of 2021 when banks may no longer offer new LIBOR-based contracts. The SOFR First market best practice recommends keeping interdealer brokers’ screens for LIBOR linear swaps available for informational purposes, but not trading activity, until October 22, 2021. After this date, these screens should be turned off altogether. The remaining SOFR First phases involve cross currency swaps, non-linear derivatives, and exchange traded derivatives.
What is Term SOFR?
Term SOFR is a forward-looking rate determined by market expectations of future SOFR settings. It covers a period longer than a business day, for example one-, three-, six-, and twelve-month periods.
On July 29, 2021, the ARRC announced that it is formally recommending the CME Group's SOFR Term Rates to further support the transition from LIBOR. The ARRC published its “Best Practice Recommendations Related to Scope of Use of the Term Rate” which states that end users may use SOFR Term Rates for derivatives intended to hedge cash products that are indexed to the SOFR Term Rate. It is important to note that SOFR Term Rates are not credit sensitive. Interdealer brokers are still expected to transition to using SOFR linear swaps, following the SOFR First initiative.
How does SOFR compare to other credit-sensitive rates like AMERIBOR and BSBY?
The risk-free nature of SOFR brings challenges that have caused many banks to advocate for credit-sensitive benchmark rates developed in the private market. ISDA modified its definitions in early May 2021 to accommodate these rates — specifically, AMERIBOR and BSBY. We have prepared an overview of some of the leading credit-sensitive alternative benchmarks.
What SOFR-related resources are available?
- Chatham Financial has prepared the following resources:
- The New York Fed publishes the following SOFR rates each business day at 8 a.m. EST:
USD LIBOR and SOFR Forward Curves
The Secured Overnight Financing Rate (SOFR) forward curve represents the implied forward rate based on SOFR futures contracts. Both curves reflect future expectations of Federal Open Market Committee (FOMC) policy, but LIBOR is a forward-looking term rate while SOFR is an overnight rate.
For informational purposes only
Speak to a Chatham expert
Please reach out to the Chatham team if you have questions around the USD LIBOR transition or how the use of SOFR in your loans and derivatives could impact your interest rate exposure.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0313
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