The central role of the SOFR rate in modern financial markets

Why does the SOFR rate matter in today's finance?

Imagine a market where banks and large financial institutions need immediate access to cash. To achieve this, they exchange U.S. Treasury securities as collateral in what are known as repurchase agreements or “repos.” This is exactly where the Secured Overnight Financing Rate, the SOFR, comes into play, which has become the most reliable indicator for measuring the actual cost of these one-day loans.

Since 2023, the SOFR rate has fully replaced LIBOR ( London Interbank Offered Rate ) after the vulnerabilities of the latter were exposed during the financial crisis of 2008. Unlike LIBOR, which was based on estimates of what banks believed they would charge, the SOFR rate is based on actual market transactions, making it virtually impossible to manipulate.

Today, thousands of financial products—from adjustable-rate mortgages to sophisticated derivative instruments—depend on the SOFR rate as their main benchmark.

Decoding the SOFR Rate: Beyond Theory

The SOFR rate is essentially a daily snapshot of the price that financial institutions pay to access cash on a short-term basis. It is jointly administered by the Federal Reserve Bank of New York and the U.S. Treasury's Office of Financial Research.

The calculation of this rate arises from three main transaction channels:

Third-party operations: intermediaries like banks facilitate the exchange of cash and guarantees between the parties. These represent an important but smaller segment of the total volume.

GCF Repo (general guaranteed financing): these go through the Fixed Income Clearing Corporation (FICC), a clearinghouse that acts as a neutral intermediary.

Bilateral repos: direct agreements between two institutions that are also settled through FICC.

With over one trillion dollars in daily volume, the Federal Reserve Bank of New York analyzes all these operations, examines the interest rates involved, and calculates the volume-weighted median. This rigorous statistical approach minimizes distortions and outliers, ensuring a robust indicator.

How the SOFR rate works in everyday practice

Every business day at 8:00 a.m. Eastern Time, the Federal Reserve publishes the new SOFR rate. This reflects data from the previous day and provides the markets with an updated benchmark on financing costs.

Because the SOFR rate is a one-day indicator, its application in longer-term instruments requires additional calculations. This is where two derivative tools come into play:

The SOFR averages ( of 30, 90, or 180 days) average the daily rates to create a more stable number, ideal for adjustable-rate mortgages or corporate bonds.

The SOFR index, launched in 2018, tracks the cumulative evolution of the rate over time, facilitating complex calculations for structured financial products.

These tools have allowed the SOFR rate to adapt beyond its original function as a one-day interbank funding indicator.

Strengths and limitations of the SOFR rate

Clear advantages:

Radical transparency is perhaps the greatest strength: it is based on actual transactions, not assumptions or estimated reports. The inherent stability comes from the enormous daily volume, making extreme changes infrequent. The backing in Treasury bonds provides a level of security that is virtually unmatched. The global support from institutions such as the Alternative Reference Rates Committee (ARRC) has solidified its international position.

Persistent challenges:

The nature of a single day may require complex adjustments for longer duration operations. The transition from LIBOR forced the update of thousands of contracts and systems, a costly process for the entire sector. Although generally stable, the SOFR rate can experience spikes during periods of market stress, particularly when liquidity tightens.

SOFR Futures: Hedging and Speculation Tool

The Chicago Mercantile Exchange (CME) offers two main types of futures contracts on the SOFR rate:

1-Month Futures: valued at 25 dollars per basis point, based on the average SOFR over a calendar month.

3-Month Futures: valued at 12.50 dollars per basis point, reflecting quarterly averages.

A bank concerned about the SOFR rate rising (making its loans more expensive) can buy these futures as insurance. Conversely, those anticipating a decline could sell them to capitalize. Futures are settled in cash based on the rate published by the Federal Reserve, without the exchange of securities or physical money.

The prices of these contracts reflect the market's collective expectations about future rates, providing valuable signals for those analyzing the direction of monetary policy.

Comparison: how the SOFR rate is positioned

Against LIBOR: the SOFR rate is based on real data while LIBOR depended on estimates. SOFR is less manipulable but requires additional calculations for long periods.

Against the Federal Funds Rate: while Federal Funds refer to unsecured bank loans, the SOFR rate covers transactions fully secured by Treasuries. SOFR has a significantly larger volume.

Against global indicators: the Euro Short-Term Rate (€STR) and the Sterling Overnight Index Average (SONIA) serve similar functions in their respective areas, but the SOFR rate is unique due to its deep reliance on the U.S. repo market.

Connections between the SOFR rate and cryptocurrency markets

Although the SOFR rate does not directly move the price of Bitcoin or Ethereum, it exerts an indirect but significant influence on the sentiment of the digital asset market.

When financing costs in traditional finance rise (reflected in a rising SOFR rate), institutional investors often pull back from speculative assets like cryptocurrencies, moving toward bonds and cash. This effect is amplified during periods of restrictive monetary policy.

Conversely, a bearish SOFR rate tends to correlate with a greater willingness to take risks, which has historically benefited cryptocurrency markets.

The prices of SOFR futures traded on the CME also serve as a barometer of future rate expectations, indirectly affecting investment decisions across the alternative asset ecosystem.

Final reflections on the SOFR rate

The SOFR rate represents a fundamental advancement in the architecture of financial markets. Its transition from LIBOR was not merely technical, but a security reform that eliminated exploitable weaknesses. With deep roots in real transactions and backed by the safest available assets (Treasury bonds), the SOFR rate is likely to remain the dominant benchmark for decades.

The public data from the New York Federal Reserve and the CME provides complete transparency for those who wish to monitor this critical metric, facilitating both monetary policy analysis and informed investment decisions.