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Interest Rate Derivatives
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SOFR reflects the cost of borrowing U.S. dollars overnight using Treasury securities as collateral. The rate is published daily by the Federal Reserve Bank of New York based on transactions in the repo market. This market is one of the most liquid and deep markets globally, providing a reliable basis for determining SOFR.
Unlike LIBOR, which was based on estimated borrowing rates between banks and exposed to manipulation, SOFR is based on observable transactions. This transparency addresses the shortcomings of LIBOR, making SOFR a more robust and dependable benchmark.
Before SOFR, LIBOR was the primary interest rate used in global financial markets, covering five major currencies: USD, EUR, GBP, JPY, and CHF.
It was based on the average interest rate at which major global banks borrowed from one another, most notably using the three-month U.S. dollar LIBOR rate. However, LIBOR’s vulnerability became evident following the 2008 financial crisis. Regulators discovered that banks were manipulating LIBOR rates to their advantage, leading to major fines and global efforts to find more reliable alternatives.
In response, regulators, particularly in the U.S., took steps to replace LIBOR. In 2017, the Federal Reserve created the Alternative Reference Rates Committee (ARRC), which selected SOFR as the replacement for LIBOR. The Federal Reserve Bank of New York began publishing SOFR in April 2018 to help financial institutions transition away from LIBOR.
This culminated in the official cessation of LIBOR in June 2023, after a transition period that began in November 2020, when banks were instructed to stop writing contracts tied to LIBOR.
While both LIBOR and SOFR serve as benchmark interest rates, their methodologies differ significantly:
This distinction is crucial because SOFR’s reliance on real transactions makes it less prone to the kind of manipulation that plagued LIBOR. Additionally, SOFR reflects a secured rate (backed by collateral, such as U.S. Treasuries), whereas LIBOR was based on unsecured interbank loans, leading to fundamental differences in how the two rates behave in times of market stress.
The transition from LIBOR to SOFR was a multi-year process. On November 30, 2020, the Federal Reserve announced that LIBOR would be phased out by the end of June 2023. Financial institutions were instructed to stop writing new contracts using LIBOR by December 31 2021, to ensure a smooth transition to SOFR.
During this transition period, both LIBOR and SOFR were in use. However, SOFR eventually became the sole benchmark for new contracts in the U.S. financial markets by mid-2023.
The shift from LIBOR to SOFR posed challenges, particularly in the derivatives market, where trillions of dollars’ worth of contracts were tied to LIBOR. Additionally, the transition affected consumer credit products, such as adjustable-rate mortgages and private student loans.
For example, mortgage holders with loans based on SOFR could see changes in their interest rates when their loan resets, depending on fluctuations in SOFR.
SOFR plays a pivotal role in the pricing of various financial products. It is most commonly used in interest-rate swaps, where two parties agree to exchange interest payments based on fixed and floating rates. For example, in a standard swap, one party agrees to pay a fixed interest rate, while the other party pays a floating rate based on SOFR. If SOFR rises, the floating-rate payer benefits, as the incoming SOFR-based payments increase. Conversely, if SOFR falls, the fixed-rate payer benefits.
SOFR is also used in adjustable-rate mortgages (ARMs) and commercial loans, where the benchmark rate determines how much interest borrowers pay when their loan resets.
Countries around the world have developed their own alternatives to LIBOR, otherwise known as Alternative Reference Rates (ARRs):
These benchmarks, like SOFR, are based on actual transactions, making them more reliable than the previous LIBOR system.
The Secured Overnight Financing Rate (SOFR) has successfully replaced LIBOR as the benchmark rate for U.S. dollar-denominated loans and derivatives. By relying on actual market transactions rather than estimates, SOFR offers a more transparent and reliable measure of borrowing costs. Its introduction has helped restore confidence in benchmark rates, ensuring that financial products tied to interest rates are grounded in observable data and less prone to manipulation.
