Once upon a time, Libor—the London Interbank Offered Rate—was the most important benchmark for setting interest rates on commercial and consumer loans. But multiple scandals and a starring role in the 2008 financial crisis doomed Libor.
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.
What Is SOFR?
SOFR is a benchmark that financial institutions use to price loans for businesses and consumers. The overnight financing part of its name references how SOFR sets rates for lenders: It’s based on the rates that large financial institutions pay each other for overnight loans.
“SOFR provides a robust and transparent method for determining a common benchmark rate based on observed, cleared transactions in the marketplace,” says Sam Weller, Senior Vice President and Director of Capital Markets at Bryn Mawr Trust.
That last part is key. Libor was based on the rates that financial institutions said they would offer each other for short-term loans. But SOFR takes into account actual lending transactions between institutions, making it more reliable than Libor, which Weller says was subject to insider manipulation.
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How Does SOFR Work?
Big financial institutions lend money to each other using Treasury bond repurchase agreements, which financial pros call repos. These repo agreements allow banks to make overnight loans to meet liquidity and reserve requirements, using Treasurys as collateral.
SOFR comprises the weighted averages of the rates charged in these repo transactions. Every morning, the New York Federal Reserve Bank publishes the SOFR rate it has calculated for repo transactions on the previous business day.
Since 2019, billions of dollars in floating-rate notes tied to SOFR have been issued in the United States, according to Ajay Patel, the Thomos S. Goho Chair in Finance at the School of Business at Wake Forest University.
Why Did SOFR Replace Libor?
Libor had been one of the main benchmarks for loans since the mid-1980s. However, Libor was marred by a series of scandals and concerns about inaccuracy due to manipulation.
“The financial crisis of 2008 and 2009 revealed some of the technical shortcomings of Libor,” Weller says. “Various Libor rate fixing scandals have made it clear to banking regulators that a more robust, risk-free reference is needed as a permanent replacement for Libor.”
These scandals were in part driven, or allowed by, the interbank lending market shrinking in recent years, notes Patel. With fewer transactions, he says, the index began reflecting quoted rates, rather than actual rates from transactions. And “this self-reported Libor rate may not accurately represent the true cost of borrowing,” notes Weller.
SOFR is much less likely to be manipulated as the Treasury repo market is one of the most liquid markets in the world, which means there’s much more real transaction data to rely on, rather than self-reported hypothetical rates.
“This market averages over $1 trillion daily, which means it reflects actual transactions, not quotes, and can’t be manipulated easily,” Patel says.
SOFR vs. Libor: What’s the Difference?
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.
However, there are other differences in the two rates.
“One key difference between Libor and SOFR is that Libor was forward-looking while SOFR is backward-looking,” Patel says. “This means that with Libor banks knew what the borrowing rate was at the beginning of the period. But since SOFR is backward-looking, the borrower won’t know exactly what they owe until the end of the loan.”
Additionally, Patel points out, Libor was unsecured—the loans it was based on didn’t use collateral—so it included a credit risk premium. 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.
However, Patel expects some rates based on SOFR to add a credit spread to make it more closely reflect the need for pricing in adjustable-rate products.
Other Alternatives to Libor
While SOFR has been getting a lot of attention, it’s not the only Libor replacement. Other Libor alternatives used in the U.S. or overseas include:
- Sterling Overnight Index Average (SONIA). In the United Kingdom, SONIA should replace Libor in 2021. Administered by the Bank of England, SONIA reflects the average rates for overnight UK Pound-denominated loans among banks and financial institutions.
- Federal Funds Overnight Index. The federal funds rate is what U.S. banks pay each other for unsecured loans from their reserves held at the Federal Reserve. The index of these rates may also be used to replace Libor by certain lenders.
- Ameribor. Created by the American Financial Exchange (AFX), Ameribor is an index based on the unsecured borrowing costs of small and medium-sized banks across the U.S. The information is stored via blockchain and an index is created using a credit-weighted average of the unsecured loans involved.
- U.S. prime rate. The prime rate has been used for years as a benchmark for setting credit card, home equity line of credit and other APRs. The prime rate is based, in part, on the federal funds rate.
What Does SOFR Mean for You?
According to Patel, few consumers should notice any impact during the shift from Libor to SOFR. The change will mostly impact financial institutions, though if you look at loan interest rates you may find a notation that they’re now calculated based on SOFR, rather than Libor.
Although the shift from Libor to SOFR has already begun, it might take years for the switchover to be complete.
“Borrowers considering adjustable-rate mortgages are already seeing SOFR pricing, and this trend will continue across other types of adjustable-rate consumer products,” Weller says. “Financial institutions have been preparing for this Libor-to-SOFR transition for years.”
That said, it will still take some time for current Libor borrowing agreements to work through the system. As a result, existing contracts will still be part of the landscape for years to come.
“The transition from Libor to SOFR represents a huge change in the plumbing of the global financial system,” Weller says. “Although we haven’t quite seen the end of Libor, it will certainly become less visible in the years to come.”
To view current SOFR rates, visit the New York Federal Reserve’s website. The New York Fed is the calculation administrator for SOFR and publishes the rate daily.
