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. 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 daily 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:

1. Tri-party repo data
2. General Collateral Finance (GCF) repurchase agreements transaction data
3. 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., 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.

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.

What are the various conventions of SOFR?

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.

• Daily Simple SOFR: Also known as “Daily Average SOFR,” this rate represents a daily weighted average (weights applied for weekends and holidays) of daily SOFR over an interest accrual period, without compounding. Various conventions can be applied in terms of lookback days or payment delays to facilitate a gap between a payment amount being known versus due.
• SOFR Compounded in Arrears: Also known colloquially as “SOFR-compound,” this rate follows the Daily Simple SOFR convention but includes the element of compounding each day of interest during the accrual period. It will also apply lookback or payment delay conventions as described above. It is worth noting this is the rate used in ISDA’s LIBOR fallback mechanism for derivatives. That being the case, banks are using SOFR-compound to trade with each other, resulting in this being the most liquid variation on SOFR. This rate is also the status quo for derivative trades that don’t hedge an underlying floating index (e.g., receive-fixed swaps and pre-issuance hedges).
• NY Fed Average SOFR: For a given accrual period (commonly 30 days), this rate takes a compounded average of the prior accrual period, such that the rate is known at the beginning of an interest period. For example, interest during an accrual period across the month of April, due at the end of April, is known at the beginning of April based on compounded average SOFR rates during March. This rate has the obvious advantage of being known at the beginning of a period but the disadvantage of being potentially unrepresentative of the actual rate environment during an accrual period. Since Q4 2020, Freddie Mac and Fannie Mae have only offered floating-rate loans indexed to NY Fed Average SOFR and have not yet provided an indication of whether and when they will use any other convention.
• CME Term SOFR: The only pure forward-looking SOFR rate, CME Term SOFR uses SOFR futures and benchmark SOFR derivatives to provide a forward rate for a given time period (e.g., one, three, six, of twelve months). Absent the inclusion of any credit-sensitive element, CME Term SOFR mimics LIBOR in that it sets at the beginning of an interest period based on forward-looking market data. Notably, CME Term SOFR is at the top of the ARRC’s LIBOR fallback waterfall for loans. Because of its operational advantages, many borrowers and lenders have expressed a preference for this rate. Also of note, regulators have clarified that in derivatives markets, CME Term SOFR is only made available to “end users” (i.e., companies using derivatives to hedge commercial risk). This means that banks are not trading CME Term SOFR-linked derivatives with each other, which limits total liquidity of the index. Borrowers should be aware of potential hedging costs for this index, though in most cases the additional cost to hedge appears to be relatively minimal.

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 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.

What SOFR-related resources are available?

• Chatham Financial has prepared the following resources:
  • LIBOR Transition Resource Stream
  • FAQ: USD LIBOR Transition to SOFR
  • LIBOR transition update
  • SOFR Daily Rates
  • USD LIBOR and SOFR Forward Curves
  • USD LIBOR transition: credit-sensitive fallback rates
• The New York Fed publishes the following SOFR rates each business day at 8 a.m. EST:
  • Daily spot SOFR
  • SOFR averages - compounded averages of the SOFR over rolling 30-, 90-, and 180-calendar day periods
  • SOFR index - reflects the cumulative impact of compounding the SOFR on a unit of investment over time, allowing for calculation of compounded SOFR averages over custom time periods