Market Mindset

The Secured Overnight Financing Rate (SOFR) replaced the London Interbank Offered Rate (LIBOR) in the UK on June 30^th, 2023. 

The LIBOR rate was a formal benchmark that had been established since 1986. It was the average short-term interest rate between banks, which was calculated each day by the Intercontinental Exchange (ICE). The methodological calculation of LIBOR was called into question, speculating that banks were augmenting the LIBOR rate to benefit their own positions. 

The LIBOR rate was structured where it could be maladapted, as the major banks would submit an interest rate that they thought they could borrow at, from other banks at various maturities. Since the rate they would submit was technically an opinion, it was not backed by tangible transactions. A bank could purport even a 0.01% difference from what it ‘should’ be, and this could even impact interest-rate derivatives for traders at their representative bank. During the run up to the global financial crisis, from 2005 to 2009, banks allegedly reported the LIBOR rate lower than their actual borrowing costs, which made them appear more financially stable to control perception about their financial health. 

Accordingly, the FCA in accordance with the BofE decided to revamp this rate, along with the Alternative Reference Rates Committee in the US. 

The result was creating a rate which was based on tangible transactions, in which to minimise credit risk distortions, offering transparency, and was nearly risk-free. Candidates choose a range of options, such as Ameribor (American Interbank Offered Rate), BSBY (Bloomberg Short-Term Bank Yield Index), ICE Bank Yield Index, but SOFR was eventually landed on as the suitable choice. 

SOFR is based on overnight treasury repo transactions. There are over $1 trillion worth of transactions a day in treasury repo trades everyday – this is a measure very hard to manipulate and robust, and its public data available.

Disclaimer: not financial advice