The most significant benchmark for determining interest rates on consumer and business loans was once LIBOR (London Interbank Offered Rate). But it was doomed by various scandals and its prominent position in the 2008 financial crisis.
Over time, in the U.S., the Secured Overnight Financing Rate (SOFR) has taken the position of LIBOR. Continue reading the article to know about SOFR, how it differs from LIBOR, and how it impacts the financial market.
What is the Secured Overnight Financing Rate (SOFR)?
Before understanding the Secured Overnight Financing Rate (SOFR), let us know the definition of the Overnight Rate.
The benchmark interest rate that depository organizations like banks and credit unions charge one another for lending money for a single night is the Overnight Rate. It is closely related to banking operations and liquidity issues. This rate has different names depending on the country. For example, it is referred to as the Federal Funds Rate in the United States, the Policy Interest Rate in Canada and the Marginal Standing Facility Rate in India.
A general indicator of the cost of overnight cash borrowing secured by treasury securities is the Secured Overnight Financing Rate (SOFR). The New York Fed releases SOFR daily, and it was first published in April 2018.
In place of the London Interbank Offered Rate, the Secured Overnight Financing Rate (SOFR) serves as the benchmark interest rate for loans and derivatives denominated in dollars.
What is the impact of change in the Overnight Rate?
The Overnight Rate may indirectly affect mortgage rates if it rises. When the Overnight Rate is high, it is expensive for banks to pay off their debts. Thus, they raise the rates on long-term loans to make up for the high Overnight Rates, which in turn directly impact the country’s employment, economic growth, and inflation. The central bank might cut the Overnight Rate for monetary expansion if there is evidence that the economy is expanding.
On the other hand, when the rate is low, banks and other financial organizations can lend and borrow more frequently, promoting economic expansion. Also, lower Overnight Rates suggest that consumers and businesses will have easier access to loans. As a result, the commercial sector expands due to the additional cash business expansion and investor attraction. The purchasing power of consumers likewise rises when commercial activity expands.
In short, taking out a loan will cost you extra money if the Overnight Rate is high. On the other hand, low Overnight Rates imply that lending activities have access to liquid capital. Overall, an Overnight Rate can assess a country’s economy and banking system health.
What is the significance of the Secured Overnight Financing Rate (SOFR)?
Financial institutions utilize SOFR as a benchmark when determining the cost of consumer and business loans. In addition, it is essential in trading derivatives, especially interest-rate swaps, which businesses and other parties use to manage interest-rate risk and speculate on changes in borrowing costs.
How Secured Overnight Financing Rate is calculated?
The volume-weighted median of transaction data from three repo markets, such as the Tri-party Repo Market, General Collateral Finance (GCF) Repo Market, and Bilateral Repo Market, is used by the New York Fed in its calculation and publication of SOFR data.
The rate is determined based on the weighted average number of transactions from the previous day. Every day at 8 AM ET, the New York Federal Reserve Bank posts the SOFR rate on its official website.
Adaptation to the Secured Overnight Financing Rate (SOFR)
The Secured Overnight Financing Rate (SOFR) and LIBOR will coexist for now. The former, however, is anticipated to displace LIBOR as the primary benchmark for dollar-denominated derivatives and credit instruments during the following several years.
The Federal Reserve said on November 30, 2020, that LIBOR would be phased out and eventually replaced by June 2023. The same announcement urged banks to stop drafting LIBOR-based contracts by the end of 2021 and to complete all LIBOR-based agreements by June 30, 2023.
India’s Marginal Standing Facility Rate
In India, the Reserve Bank of India’s Marginal Standing Facility Rate, or MSF, is a key guideline that allows some commercial banks to obtain overnight liquidity. After all liquids have dried up, this is helpful. Banks can acquire liquidity at the Marginal Standing Facility, or MSF rate, through MSF as an emergency tool.
By pledging government assets at a rate higher than the repo rate, the concerned banks can borrow money from the central bank using the Marginal Standing Facility, or MSF. This will enable the banks to get immediate cash within a 24-hour.
Secured Overnight Financing Rate (SOFR) vs. LIBOR
| Secured Overnight Financing Rate (SOFR) | London Interbank Offer Rate (LIBOR) |
| Uses actual transactional data from the U.S. Treasury market | Based on bank borrowing estimations |
| Secured by Government bonds | No need to pledge any collateral |
| Mandatory to collateralize the transaction with treasury security | No collateral is required to secure the financing; therefore, it is an unsecured loan
|
| Considers into account actual lending transactions between institutions, making it more reliable than LIBOR | Based on the rates that financial institutions would offer each other for short-term loans, and is prone to manipulation |
How SOFR impacts the Indian Stock market?
The U.S. Fed’s changes to interest rates have an impact on global liquidity, which in turn affects stock prices all around the world. Liquidity and earnings significantly determine stock values over long and short terms. Rate cuts will always help emerging markets like India because they will attract foreign investors with the significant returns they promise.
Conclusion
Compared to LIBOR, SOFR is a risk-free rate based on overnight treasury transactions. Because of how it is generated and the size and liquidity of the markets that support it, SOFR is a rate that is far more resilient than LIBOR. The SOFR more accurately depicts the current funding method used by financial institutions as it is an overnight secured rate.
Disclaimer
- This blog is exclusively for educational purposes
- Investments in the securities market are subject to market risks; read all the related documents carefully before investing
