Get Forbes Advisor’s expert insights on investing in a variety of financial instruments, from stocks and bonds to cryptocurrencies and more. The Secured Overnight Financing Rate (SOFR) is Libor’s replacement in the United States. Here’s what you need to know about SOFR, how it differs from Libor and how you might be impacted by the change.

1. As noted above, a key difference between SOFR and Libor is the fact that the former is based on completed financial transactions while the latter relied on quotes from reporting banks that were not necessarily from actual financial transactions.
2. The Secured Overnight Financing Rate (SOFR) is the overnight interest rate for US dollar-denominated loans and derivatives.
3. Derived from real transactions, SOFR offers insights into market liquidity and financial stability, reflecting the current state of the lending and borrowing environment.
4. The IMM dates, or the third Wednesdays, are September 18, 2019 and December 18, 2019.
5. That kind of growth likely means the Fed will have achieved a coveted “soft landing” by restraining the economy enough to tamp down inflation without triggering a recession.

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The five currencies were the U.S. dollar (USD), euro (EUR), British pound (GBP), Japanese yen (JPY), and the Swiss franc (CHF). The most commonly quoted LIBOR was the three-month U.S. dollar rate, at the time referred to as the current LIBOR rate. SOFR’s establishment, grounded in actual market transactions, marks a significant evolution in financial benchmarks.

By employing SOFR as supposed to LIBOR, lenders are simply increasing the likelihood of change. As we’ve said many times, that change could result in rates that save you money, rates that increase your monthly payment or rates that are essentially a wash. While it’s true that LIBOR has been the leading benchmark for many in the banking and mortgage industry since 1986, it wasn’t then, nor is it now, the https://traderoom.info/ only game in town. However, the industry came to the conclusion fairly early on that LIBOR provided the most accurate benchmark for determining ARM rates, thus cementing its position as the go-to reference rate for variable rate mortgages over the past four decades. By contrast, SOFR is a fully transaction-based rate, making it less susceptible to market manipulation and more appealing to regulators.

Why Did SOFR Replace Libor?

SOFR is a secured rate, based on transactions that involve collateral, in the form of Treasuries, so there’s no credit risk premium baked into the rates. Unlike the LIBOR, there’s extensive trading in the Treasury repo market—roughly $4.8 trillion in June 2023—theoretically making it a more accurate indicator of borrowing costs. Following the financial crisis of 2008, regulators grew wary of overreliance on LIBOR. For one, it was based largely on estimates from global banks that were surveyed—but not necessarily on actual transactions. The LIBOR was previously the go-to interest rate at which investors and banks pegged their credit agreements to. Comprised of five currencies and seven maturities, the LIBOR was determined by calculating the average interest rate at which major global banks borrow from one another.

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Adopting a waterfall, data-driven methodology and incorporating a forward-looking model, lenders issuing ARMs did not hesitate to employ LIBOR as one half of their fully indexed interest rate. While talk of index rates is not likely to dominate water cooler conversations (or their digital equivalent) anytime soon, there are some interesting developments for a couple interest rate indices that impact adjustable rate mortgages (ARMs). The final calculation then for the entire contract period will include both compounded rates and simple interest.

What Is the Secured Overnight Financing Rate (SOFR)?

The European Central Bank (ECB), on the other hand, opted to use the Euro Overnight Index Average (EONIA), which is based on unsecured overnight loans, while Japan applied its own rate, called the Tokyo overnight average rate (TONAR). Moreover, the Secured Overnight videforex Financing Rate (SOFR) is based on data from observable transactions rather than on estimated (or falsified) borrowing rates, as was generally the case with LIBOR. The latest published SOFR 1-month, 3-month, and 6-month averages are for February 1, 2024.

In 2017, the Federal Reserve (Fed) responded by assembling the Alternative Reference Rate Committee, composed of several large banks, to select an alternative reference rate for the United States. The committee chose the Secured Overnight Financing Rate (SOFR), an overnight rate, as the new benchmark for dollar-denominated contracts. In addition, banking regulations after the financial crisis meant that there was less interbank borrowing happening, prompting some officials to express concern that the limited volume of trading activity made the LIBOR even less reliable. Eventually, the British regulator that compiled LIBOR rates said it would no longer require banks to submit interbank lending information after 2021. This update sent developed countries around the world scrambling to find an alternative reference rate that could eventually replace it. While investors may pay the most attention to the Federal Reserve’s target range for the federal funds rate, which influences borrowing costs across the economy, two other types of interest rates, real and neutral, are giving it some competition.

Powell also said he’s keeping a close eye on to what extent goods disinflation (and deflation) continues and whether inflation for services continues to fall. Fed Chair Jerome Powell said Wednesday the US economy has yet to achieve a soft landing, noting that “we still have a ways to go.” Preliminary fourth-quarter productivity data is due out on Thursday from the Bureau of Labor Statistics. Diane Swonk, chief economist of KPMG, told CNN this week that rising productivity could likely be attributed as a result of the interest rate hikes and the labor market getting back into better balance following the pandemic recovery.

The index would serve as a benchmark, providing one part of the fully indexed interest rate along with the lender-appointed margin. SOFR stands for the “Secured Overnight Financing Rate” and represents the borrowing costs of cash collateralized by Treasury securities based on transactions in the “repo” market. One difficulty is that in the absence of SOFR-based term rates, SOFR compounded in arrears currently is the preferred replacement rate in many products. Calculated over the current interest period, it leaves little notice time before payment and poses significant operation disadvantages for some cash products (e.g., syndicated loans). A solution for this challenge would be to develop SOFR-based term rates, which are expected in the first half of 2021. However, the robustness of such rates would depend on the liquidity of relevant SOFR derivatives.

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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 has 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. In contrast to the different term LIBORs (i.e., one-month LIBOR, three-month LIBOR, etc.), it is an overnight, fully secured rate. Chatham’s U.S. market data includes daily SOFR and SOFR/Term SOFR swap rates. Additionally, Patel points out, Libor was unsecured—the loans it was based on didn’t use collateral—so it included a credit risk premium.