SOFR (Secured Overnight Financing Rate) is a
risk-free rate calculated based on the cost of borrowing overnight, secured by U.S. Treasury securities. In contrast, LIBOR (London Interbank Offered Rate) reflected the credit and liquidity risks of banks lending to each other, making it an
unsecured rate.
While LIBOR is based on banks’ estimates, SOFR is derived from actual transactions in the repo market, making it more reliable. LIBOR offers multiple maturities (overnight, 1-month, 3-month, etc.), whereas SOFR is currently available at an overnight rate.
The transition away from LIBOR has huge implications for anyone working in asset management, trading, or risk management, especially in advanced swaps.
So, how does SOFR vs LIBOR compare, and why does it matter for swaps?
Why the Change from LIBOR to SOFR?
The big question is, why did the world decide to replace LIBOR?
LIBOR was once the king of reference rates. Banks would report the rates at which they could borrow from each other, and LIBOR was the average. It was used to price trillions of dollars in loans,
bonds and derivatives, including swaps. Sounds great, right?
But here’s the catch:
LIBOR was based on banks’ estimates, not actual transactions. During the 2008 financial crisis, it became clear that this system was vulnerable to manipulation. Some banks were found to be
falsifying their reported rates to make themselves appear more creditworthy than they were. As trust in LIBOR eroded, regulators worldwide decided it was time to move on. LIBOR officially ended in June 2023.
Enter SOFR. Unlike LIBOR, SOFR is based on actual transactions in the U.S. Treasury repurchase (repo) market, making it more reliable. The transition from LIBOR to SOFR is crucial for financial stability, but it brings challenges, particularly for those involved in
advanced swaps.
How Does SOFR Differ from LIBOR?
SOFR is calculated based on the cost of borrowing overnight, secured by U.S. Treasury securities, which makes it a risk-free rate. In contrast, LIBOR reflects the credit risk of banks lending to each other and is thus an unsecured rate.
Key Differences:
- Risk Profile:
- LIBOR: Includes credit risk and liquidity risk.
- SOFR: Risk-free rate since it's secured by U.S. Treasury securities.
- Calculation Basis:
- LIBOR: Based on banks’ estimates (which can be manipulated).
- SOFR: Based on real, observed transactions in the repo market, making it more robust.
- Term Structure:
- LIBOR: Available for various maturities (overnight, 1 month, 3 months, etc.).
- SOFR: Currently available as an overnight rate, but term versions are being developed.
Example: How SOFR Impacts Swaps
Let’s say you’re dealing with a plain vanilla interest rate swap, a common tool used by asset managers and traders. In the past, many swaps were linked to LIBOR. In this example, your company pays a fixed rate and receives a floating rate based on LIBOR.
With the transition to SOFR, the floating leg of the swap will now be tied to SOFR instead of LIBOR.
The key change?
SOFR tends to be lower than LIBOR because it’s a
risk-free rate. Therefore, if you’re receiving SOFR instead of LIBOR, you’ll likely get a smaller payout on the floating leg.
But there’s more! Since LIBOR had term structures (1-month, 3-month rates, etc.), while SOFR is primarily overnight, adjustments are needed to ensure payments align over different periods. This means calculating averages or compounding SOFR to match the timing of swap payments.
Since SOFR is lower and more stable than LIBOR, basis swaps will see tighter spreads. Traders and risk managers will need to adjust their models and strategies accordingly. The reduction in credit risk makes SOFR swaps less volatile, but the challenge lies in pricing them accurately and understanding the implications of this new dynamic.
Challenges in the Transition: How Does This Affect You?
Switching from LIBOR to SOFR isn’t a simple swap (pun intended). One of the hurdles, for example, is
Legacy Contracts. There are billions of dollars in contracts that reference LIBOR, many of which extend beyond its end date in June 2023. These contracts need to be renegotiated or transitioned to SOFR, which can be time-consuming and expensive.
For those in asset management, trading, or risk management, understanding SOFR is now essential.
If you're pricing swaps or hedging against interest rate fluctuations, the transition means you need to rethink your strategies and tools. SOFR vs LIBOR is different in many fundamental ways, and you’ll need to adapt your calculations, models, and expectations accordingly.
The Future of Swaps in a Post-LIBOR World
SOFR is here to stay, and as the financial world adapts, so must you.
The lower and more stable nature of SOFR means less credit risk in swaps, but it also means a shift in how returns are calculated. Expect to see a growing number of swaps tied to SOFR as liquidity improves and more market participants make the switch.
Now that LIBOR’s days are over, the need to understand SOFR and its impact on advanced swaps is more pressing than ever. Whether you’re involved in middle office operations, compliance, or risk management, SOFR is now part of your daily landscape. The more you know about it, the better equipped you’ll be to navigate the changing environment.
Ready to dive deeper?
If you’re ready to master advanced swaps and learn more about how the LIBOR-to-SOFR transition affects the market, check out our
Advanced Swaps course! This course will help you understand complex swap structures, manage interest rate risks, and stay ahead in today’s rapidly changing financial world. Don’t wait— enrol today and take your expertise to the next level!
FAQs
What is the difference between SONIA and SOFR?
The main difference between SONIA (Sterling Overnight Index Average) and SOFR (Secured Overnight Financing Rate) is their underlying markets and currencies. SONIA is based on unsecured overnight sterling (GBP) transactions in the UK, reflecting interest rates banks pay for lending without collateral. SOFR, on the other hand, is based on overnight loans in the U.S. Treasury repo market, making it a secured and risk-free rate in U.S. dollars (USD). Both are risk-free rates but apply to different currencies and markets.
Are other countries moving to RFRs?
More and more countries are moving towards, what is termed an RFR (Risk-Free Rate). What that term really means can vary. While others will keep an IBOR rate (like Libor, but set in the local market, not London).