Secured Overnight Financing Rate

Secured overnight financing rate (SOFR) is the cost of borrowing cash secured after pledging treasury securities as collateral and is based on the U.S. repo market’s transactions. The fees large financial institutions lend each for overnight loans change every day. It replaces London Interbank Offered Rate (LIBOR) in the United States.

The key participants of the repo market include large corporations, banks, other financial institutions, and government agencies like the central bank and municipalities. The New York Federal Reserve Bank publishes the SOFR rate every morning for the repo transactions on the preceding business day based on the volume-weighted median of such transactions. SOFR is also considered less risky than LIBOR, which the former replaced.

• A secured overnight financing rate is a benchmark rate between banks or financial institutions for loans that the borrower would settle with interest the next day. In addition, Treasury securities (Government Bonds) as collateral is mandatory.
• The rate is calculated based on the weighted-average volume of transactions the previous day. The New York Federal Reserve Bank publishes the SOFR rate daily on its official website at 8 AM ET.
• SOFR is the replacement for LIBOR, which was prone to manipulation and unethical activities.
• SOFR rate is helpful in the derivative market, especially for trading interest rate swap transactions.

The secured overnight financing rate refers to the interest the bank is liable to pay to the bank for the overnight financing or borrowing received in the United States. It depends on the assumption that the borrowing bank will return the loan with the next day's SOFR interest rate. This rate was formerly called Treasuries Financing Rate.

Other countries have their overnight rates, such as SONIA in Great Britain's sterling market or the Euro Overnight Index Average (EONIA) in the EU.

Similar benchmark transactions for derivatives and dollar-denominated loans were initially charged based on the LIBOR. However, after unfair manipulation and unethical activities became rampant, SOFR emerged as a replacement that banks across the globe were in search to replace LIBOR.

It was initiated and implemented in 2017 and will replace LIBOR entirely by 2023. The fundamental difference between the two benchmark rates is that LIBOR relies on borrowing estimates by banks, whereas SOFR uses factual transactional data in the United States treasuries market. Additionally, while government bonds secure SOFR, LIBOR does not require any collateral to be pledged.

SOFR relies on treasury repurchase agreements. They are short-term lending agreements that require collateral to be pledged. The rates are published daily by The Federal Reserve Bank of New York based on the transactions from the previous business day.

However, banks depend on a rolling average rate to ensure smooth daily volatility. Therefore, the average is calculated over a rolling period of 30, 90, or 180 days using the secured overnight financing rate history of the respective period.

Let us understand the application of this revolutionary rate through the examples below:

Example #1

ABC Bank has an average daily cash requirement of $100 million to cater to the 20 branches in the city and its customers. On the 12^th of December, they had a cash reserve of $70 million towards the end of business hours.

To meet its reserve and liquidity requirements, they secured an overnight loan from XYZ bank for $30 million, for which they produced government bonds they held as collateral.

The next day, on the 13^th of December, ABC Bank returned the money with the SOFR rate declared by the New York Federal Reserve that morning to XYZ Bank.

Example #2

Express, Inc., the fashion retailing giant headquartered in Columbus, Ohio. They declared their third quarter results for 2022, which mentioned having an existing loan of $40 million, which was increased to $290 million.

During this deal, the interest rates were reduced from 2% to 2.25% according to the LIBOR benchmark to 1.60% to 1.85% under the SOFR benchmark.

Although the induction of SOFR comes as a replacement in light of its predecessor coming under scrutiny for breeding unethical activities, SOFR still has its share of advantages and disadvantages. Let us discuss the points below:

Pros

#1 - Credibility

Since the Federal Reserve Bank of New York releases SOFR rates daily, it is an unexpressed certification of the credibility and genuineness of such rates. The NY Federal Reserve is, in fact, next in line with the top regulatory banks in the United States banking system.

#2 - Manipulation-Free

Since the rates are based on actual transactions, the chances of manipulation are second to none compared to LIBOR, the previous benchmark.

#3 - Resilience

Owing to the process of how the rate is derived and the liquidity and depth in the underlying markets, it is more resilient than LIBOR.

Cons

#1 - Liquidity

Since the loans under LIBOR are still in practice, comparing the two shows a stark difference in their liquidity rates. The LIBOR system has more liquidity than SOFR.

#2 - Period

SOFR is an overnight rate, as in, it provides interest rates only for that limited time frame, while LIBOR is a benchmark that borrowers and lenders can use to calculate interest for up to 12 months.

#3 - Applicability

Other than the derivatives market, the usage of SOFR is relatively limited, like in the case of the cash or currency market. 

Let us understand the historical movement of SOFR in terms of price and volume of transactions through the chart below, published by the New York Federal Reserve’s official website.

This chart includes different transactions, such as the bilateral Treasury repurchase agreement (Repo) and transactions through delivery-versus-Payment (DVP).

The data collected from the U.S. Department of Treasury’s Office of Financial Research (OFR) and SOFR rate is calculated based on a volume-weighted median of the transactions from the previous day.

In 2022, the volume of transactions of this nature moved sideways. They ranged between $972 Billion and $1.1 Trillion. The peak of transactions occurred in November 2022. The very nature of SOFR implies that the rate is a reflection of the market mood or the market's current status.

Moreover, the interest rates' movement formed an upward trend ranging from 0.30% in March to 3.82% in November 2022.

Since the Federal Banks' rates are to serve as savings instruments, a hike or lowering of the fed funds rate can also result in the upward or downward movement of SOFR.

In 2023, when SOFR would replace the LIBOR benchmark system, large financial institutions and analysts have kept a close eye on its movement as it also gives a subtle outline of the state of the economy.

Since there has been a constant comparison of SOFR with LIBOR, let us understand the differences at different levels of their functions, applicability, time frames, and more through the table below:

This article has been a guide to what is Secured Overnight Financing Rate. Here, we explain its examples, chart, pros & cons, and comparison with LIBOR. You may also find some useful articles here -

• Federal Funds Rate
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