Understanding the Secured Overnight Financing Rate (SOFR)

The Secured Overnight Financing Rate (SOFR) is a crucial benchmark in the financial industry, reflecting the cost of borrowing cash overnight collateralized by Treasury securities. This article explores what SOFR is, how it's calculated, and its significance in the financial markets.

What is SOFR?

SOFR is an interest rate published by the Federal Reserve Bank of New York. It represents the average interest rate for secured loans issued in U.S. dollars with an overnight maturity. These loans are typically between financial institutions and are secured by Treasury securities, known for their liquidity and reliability.

How is SOFR Calculated?

SOFR is calculated as the volume-weighted median rate from transactions across three repo markets. The calculation excludes lower rates from transactions categorized as "specials," processed through the Fixed Clearing's Delivery-us-Payment (DVP) repo service. Special repos involve securities in high demand, leading potential purchasers to offer lower cash rates. Transactions with rates below the 25th volume-weighted percentile are excluded from the repo data pool.

Importance of SOFR

SOFR serves as an important indicator of borrowing costs for loans between banks and other entities in the repo agreement market. A rise in repo rates can suggest limited cash in a vital funding sector for Wall Street. However, the recent increase in SOFR did not trigger broader pressures in the funding market and is unlikely to impact reserve conditions or quantitative tightening.

CME Term SOFR

While SOFR provides a benchmark for overnight loans, it's challenging to use for loans with longer maturities. To address this, the Chicago Mercantile Exchange (CME) developed Term SOFR, offering forecasts of SOFR rates for periods like 1 month, 3 months, 6 months, and 12 months. These rates are calculated based on market data from SOFR futures and reflect market expectations for future SOFR rates.

Historical Data

Historical data shows that SOFR has been relatively stable, with rates fluctuating between 5.08% and 5.38% over the past few months. For instance, on June 1, 2024, the 1-day SOFR was 5.34%, while on September 30, 2024, it was 5.33%. These figures indicate a slight increase in borrowing costs over the past few months.

Conclusion

The Secured Overnight Financing Rate (SOFR) is a critical benchmark in the financial industry, reflecting the cost of borrowing cash overnight. Its calculation involves a complex process that excludes lower rates from special repo transactions. Understanding SOFR is essential for investors, financial institutions, and policymakers to navigate the complexities of the financial markets effectively.