Secured Overnight Financing Rate (SOFR)

The Secured Overnight Financing Rate is the United States reference rate for overnight borrowing secured by Treasury securities, administered by the Federal Reserve Bank of New York. The New York Fed's own definition is that it "is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities." It is not a policy rate and nobody sets it: it is calculated from the previous day's actual transactions in the Treasury repurchase agreement, or repo, market, and published each business day at approximately 8:00 a.m. Eastern time.

Most people meet it as a name in a loan document. Since US dollar LIBOR ceased, the interest rate on a great many adjustable-rate mortgages, business loans, student loan refinancings, floating-rate notes and derivatives has been quoted as a SOFR-based rate plus a margin. The rate itself is spelled out in full here because that is how the New York Fed names it; almost every contract, statute and regulation then uses the acronym.

Why it exists at all is the LIBOR story, and the difference is estimates versus transactions. The Federal Reserve convened the Alternative Reference Rates Committee in 2014, in the ARRC's own account, "and tasked the group with identifying an alternative to U.S. dollar LIBOR that was a robust, IOSCO-compliant, transaction-based rate derived from a deep and liquid market. In 2017, the ARRC fulfilled this mandate by selecting the Secured Overnight Financing Rate, or SOFR." The ARRC lists what SOFR has that LIBOR and similar rates did not, and one item is decisive: SOFR "is produced in a transparent, direct manner and is based on observable transactions, rather than being dependent on estimates, like LIBOR, or derived through models." SOFR is built from the Treasury repo market, which the ARRC calls "the largest rates market at a given maturity in the world." The committee itself finished its work and ceased operations in November 2023.

Secured and unsecured are not a technicality; they change what the number measures. LIBOR was a term rate for unsecured bank borrowing, so it embedded a premium for the risk of lending to a bank for one, three or six months. SOFR is an overnight rate fully collateralized by Treasury securities, so it carries almost none of that. Swapping one for the other without compensation would therefore have changed the economics of every existing contract, which is why the transition came with fixed spread adjustments rather than a straight substitution.

For legacy contracts with no workable fallback, Congress and the Federal Reserve substituted the rate by operation of law. The Adjustable Interest Rate (LIBOR) Act, codified at 12 U.S.C. 5801 and following, and the Board's Regulation ZZ at 12 CFR part 253 exist, in the regulation's own words, "to establish a clear and uniform process, on a nationwide basis, for replacing the overnight and one-, three-, six-, and 12-month tenors of U.S. dollar LIBOR in existing contracts" that do not provide for the use of a clearly defined or practicable replacement rate. The regulation sets the LIBOR replacement date as "the first London banking day after June 30, 2023." It deliberately does not disturb contracts that already had a workable fallback, or new contracts, where parties remain free to use any appropriate rate.

For a consumer loan caught by that regulation, the replacement is the corresponding one-, three-, six- or 12-month CME Term SOFR plus a fixed tenor spread adjustment, and the spread phases in linearly over the first year rather than arriving in a single step. The adjustments themselves are set in the regulation and do not change: 0.00644 percent for overnight LIBOR, 0.11448 percent for one-month, 0.26161 percent for three-month, 0.42826 percent for six-month and 0.71513 percent for 12-month.

An overnight rate cannot price a three-month loan, so the market built two ways around that. The first is averaging. The New York Fed publishes SOFR Averages, which are "compounded averages of the SOFR over rolling 30-, 90-, and 180-calendar day periods," together with a SOFR Index that "measures the cumulative impact of compounding the SOFR on a unit of investment over time," set to 1.00000000 on April 2, 2018, the first value date of the SOFR. The second is a forward-looking term rate, which the ARRC set as a goal and which is now published by a private administrator as CME Term SOFR and named as such in Regulation ZZ. The practical consequence for a borrower is that a rate quoted as "30-day Average SOFR plus 2.50 percent" resets from an average of the past thirty days, so it lags a change in short-term rates rather than moving with it on the day.

It can move for reasons that have nothing to do with monetary policy. Because SOFR is a repo rate, it reflects the supply of cash and collateral in that market on a particular morning, including quarter-end and year-end balance-sheet effects. Governor Christopher Waller's account of autumn 2019 is the clearest official description of what that can look like: the Federal Reserve had reduced the level of reserves through its balance sheet normalization program, heavy Treasury issuance arrived in September, and in his assessment "the level of reserves likely went a bit too low," with stresses showing up in money markets. A borrower whose rate resets off a daily print can therefore see a move that no policy decision explains, which is one practical argument for the averaged versions.

How the number is produced, in the New York Fed's own description.

1. Transactions are collected, not opinions. The rate draws on transaction-level tri-party repo data from the Bank of New York Mellon and the Treasury's Office of Financial Research, GCF Repo transaction data, and data on bilateral Treasury repo transactions cleared through the Fixed Income Clearing Corporation's Delivery-versus-Payment service.

2. A portion of "specials" is filtered out. Repos for a specific issue of collateral trade at cash-lending rates below those for general collateral repos, because cash providers accept a lower return in order to obtain a particular security. Leaving them all in would bias the rate downward.

3. The rate is a volume-weighted median. Not an average. A median is far harder to move with a small number of unusual trades, which matters for a rate that trillions of dollars of contracts reference.

4. It publishes at about 8:00 a.m. Eastern time each business day, followed shortly after by the SOFR Averages and the SOFR Index.

A hypothetical example of what the legal substitution did to one borrower's rate. Suppose a business loan was written as three-month LIBOR plus 2.00 percent, with no usable fallback provision, so Regulation ZZ applies. After the transition the rate is three-month CME Term SOFR plus the regulation's three-month tenor spread adjustment of 0.26161 percent plus the original 2.00 percent margin. If the three-month Term SOFR reading on a reset date were 4.30 percent, the rate would be 4.30 plus 0.26161 plus 2.00, which is 6.56161 percent, or about 6.56 percent. The 4.30 is a made-up reading used to show the arithmetic; the 0.26161 and the 2.00 are the fixed pieces, and they are the ones a borrower can check against the loan document and the regulation.

If the same loan were a consumer loan, the 0.26161 would not have appeared all at once. Regulation ZZ phases the spread in linearly over the year following the replacement date, starting from the actual gap between Term SOFR and LIBOR on the day before, so a consumer's rate moved gradually toward the fully adjusted figure.

Why it was chosen

• It is derived from completed transactions in a very large market rather than from banks' estimates, which is the failure LIBOR was retired over.
• It is administered by the Federal Reserve Bank of New York and published free each business day, so the input to a borrower's rate is public and checkable.
• Being a volume-weighted median rather than an average makes it resistant to distortion by a handful of unusual trades.
• The ARRC's stated reason for selecting it includes that the underlying market weathered the global financial crisis and is expected to stay active in a wide range of conditions.

The trade-offs a borrower should know about

• It is an overnight rate looking backward, so it cannot by itself price a term loan. Every consumer application uses an average or a term rate built on top of it.
• It carries almost no bank credit risk, which is why the transition needed fixed spread adjustments and why a straight comparison with an old LIBOR quote is not like for like.
• A rate that resets from an average of the past thirty, ninety or one hundred eighty days lags a change in short-term rates in both directions.
• Repo market conditions can move it independently of monetary policy, as the money-market stresses of autumn 2019 illustrated.
• Term SOFR is produced by a private administrator rather than by the New York Fed, so the forward-looking version most contracts use has a different publisher from the overnight rate itself.