The Secured Overnight Financing Rate (SOFR), a benchmark interest rate provided by the U.S. Federal Reserve System, measures the overnight borrowing cost among financial institutions. SOFR has replaced the traditional London Interbank Offered Rate (LIBOR) as the primary short-term interest rate benchmark in the U.S. market. It is considered a risk-free rate because it is backed by U.S. Treasury securities, making the likelihood of borrower default extremely low.
The history of SOFR
The London Interbank Offered Rate (LIBOR), once a commonly used interest rate that investors and banks would link their borrowing agreements to, faced a major scandal in 2012 when multiple global banks were exposed for manipulating it. This scandal led to a significant shift in regulators' attitude towards LIBOR, which was deeply embedded in the financial system due to its association with loans, derivatives, and various other financial instruments in multiple currencies, valued at approximately $300 trillion. Consequently, UK financial regulators mandated that financial firms and investors must complete their transition away from LIBOR by 2021. In June 2017, the U.S. Federal Reserve's Alternative Reference Rates Committee selected SOFR as the preferred replacement for LIBOR. On November 30, 2020, the Federal Reserve announced the phasing out of LIBOR, ultimately replacing it by June 2023.
Importance of SOFR
LIBOR's Replacement:Due to the risks of manipulation and lack of sufficient transaction data to support it, LIBOR (London Interbank Offered Rate) has been gradually phased out. SOFR has been selected as one of the primary benchmark interest rates to replace LIBOR due to its characteristics of being based on extensive actual transaction data, high transparency, and resistance to manipulation.
High Transparency: SOFR's calculation methods and data sources are publicly transparent, which is beneficial for market participants to assess risks and make decisions.
Difficult to Manipulate: SOFR is based on a wide range of market transaction data, making it difficult for a single institution to manipulate.
SOFR, as a replacement for LIBOR, has emerged as a crucial benchmark interest rate in the global financial market. It plays a vital role in enhancing the transparency of financial markets and mitigating systemic risks.
