Secured overnight financing rate (SOFR): Setting the variable interest rate standard

The secured overnight financing rate (SOFR) is an interest rate calculated by the Federal Reserve Bank of New York based on the overnight borrowing cost for secured funds (i.e., those backed by Treasury securities). It replaced the London interbank offer rate (LIBOR) as the standard benchmark for short-term borrowing among banks. SOFR is often specified in contracts—from swaps and OTC derivatives to your credit card agreement—as the basis for interest rate changes.

You may be affected by SOFR and not even know it. It’s an important rate used by financial services companies every day to set the interest rates that you might be paying. Learn about SOFR—how it’s calculated and why and when it fluctuates—to help you understand why, say, the interest on your credit card may have changed.

Finding and using SOFR

SOFR is an overnight rate that’s used as a reference rate. Let’s start by breaking these two concepts down.

Overnight rate. Banks need to meet federally mandated capital reserve requirements each night. Corporations need to meet every financial obligation, including payroll. But both banks and corporations have wide fluctuations in the amount of cash they have on hand on any given day. Sometimes a company (or a bank) has more money than it needs, so it will lend it out overnight to another entity that needs to borrow overnight. For a multinational corporation, even a tiny percentage return on such loans can represent a lot of money.

Many of these overnight loans are structured as repurchases. For example, Company A might offer to sell a Treasury security to Bank B and then buy it back the next day. Because these loans happen on a regular basis on short notice, any rapid fluctuation in the overnight rate may signal a pending change in the economy.

Reference rate. A reference rate is an “official” benchmark interest rate, and the basis for any contract that uses it. Swaps and other interest rate derivative contracts use reference rates to determine margin requirements and settlement prices. Contracts such as adjustable-rate mortgages, private student loans, and, yes, revolving lines of credit such as credit cards, also use a reference rate. The use of a standard benchmark such as SOFR can reduce transaction costs, improve market liquidity, and provide an extra layer of certainty to a contract.

SOFR is calculated each day by the Federal Reserve Bank of New York based on about $1 trillion in daily transactions processed through the Bank of New York Mellon Corporation (BNY) and the Fixed Income Clearing Corporation (FICC), a subsidiary of the Depository Trust & Clearing Corporation (DTCC). The rate is used by other banks, financial companies, and corporations when setting interest rates. For example, a contract may call for an interest rate based on a multiple of SOFR, or an adjustable-rate mortgage may move based on changes in SOFR rates.

Derivatives exchange CME Group (CME) lists SOFR futures contracts. It uses the daily settlement prices of those futures contracts to calculate and publish the CME Term SOFR Rates, which are forward estimates for SOFR rates that look out one, three, six, and 12 months. Financial institutions and corporations can use that data in their financial planning and risk management.

SOFR vs. LIBOR

SOFR was selected in 2017 to eventually replace the London interbank offered rate (LIBOR), which was used for decades as the benchmark rate for overnight rates among international banks. During the financial crisis of 2007–08, a persistent rumor that LIBOR was prone to manipulation turned out to be true. Several European banks ended up paying large fines to their financial regulators, and LIBOR lost the respect it once enjoyed among market participants. Banks experimented with alternatives, but had trouble finding one that worked as well as LIBOR was supposed to work (but ultimately didn’t).

In 2014, the Federal Reserve Bank of New York convened an Alternative Reference Rates Committee to investigate other interest rates that could replace LIBOR. They wanted a rate that came from an active underlying market with a diverse set of borrowers and lenders, so that the effects of supply and demand were clear; that was based entirely on transactions and not estimates; and that looked at multiple market segments. In 2021, the U.S. Congress passed the Adjustable Interest Rate (LIBOR) Act, which made SOFR the replacement rate for any contracts that specified LIBOR effective June 30, 2023. At that point, LIBOR was officially discontinued.

Alternatives to SOFR

SOFR isn’t the only reference rate out there. Different regions and institutions need benchmark rates that reflect their own currencies, banking systems, and market structures, so a range of reference rates developed alongside SOFR. Here are a few:

• SONIA (Sterling overnight interbank average). This rate, denominated in British pounds, has been used in the U.K. since 1997 for domestic transactions, as opposed to LIBOR, which was an international rate with versions denominated in five different currencies—the pound, U.S. dollar, Japanese yen, Swiss franc, and the euro.
• EURIBOR (Euro interbank offered rate). Similar to LIBOR, this rate tracks transactions from large European banks. Euribor is denominated in euros.
• SARON (Swiss average rate overnight). This rate looks at activity at Swiss banks, which handle transactions for customers from all over the world.
• Fed funds rate. Set by the Federal Open Market Committee (FOMC), this is the rate charged on overnight borrowing by commercial banks. It is sometimes used as a reference rate, but it is determined by the Fed rather than by pure supply and demand. 
• Prime rate. This is the interest rate used by commercial banks to price short-term business loans. The Federal Reserve tracks an average of the prime rates charged by the 25 largest U.S. banks.

SONIA, EURIBOR, and SARON aren’t denominated in U.S. dollars, so they are unlikely to affect U.S. consumers. Multinational corporations track them, though, because they often make short-term loans in different currencies. American consumers may see rates that are based on the Fed funds rate or the bank’s prime rate instead of SOFR.

The bottom line

The secured overnight financing rate (SOFR) is a standard, short-term, market-based interest rate that quietly underpins a significant—and growing—portion of the financial system. You may not follow it from day to day, but if you’ve had a credit card, a loan, or an adjustable-rate contract, you’ve likely crossed paths with SOFR or its predecessor, LIBOR. Knowing what it is can help you understand what’s driving the rates that affect you.

References

• Secured Overnight Financing Rate Data | newyorkfed.org
• CME Term SOFR Reference Rates FAQs | cmegroup.com
• Alternative Reference Rates | ice.com