Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. Introduced by the Federal Reserve Bank of New York in 2018, SOFR was developed to replace the London Interbank Offered Rate (LIBOR).

What is SOFR?

Unlike LIBOR, which is based on estimates from a panel of banks, SOFR is based on actual transactions and is thus considered a more reliable and transparent benchmark. It is a nearly risk-free rate as it is secured by U.S. Treasury securities.

Transition from LIBOR to SOFR

The transition from LIBOR to SOFR marked a significant shift in the financial landscape. LIBOR has been the dominant benchmark for interest rates on a wide range of financial products, including business loans, for decades. However, after the 2008 financial crisis, regulators identified several issues with LIBOR, including its susceptibility to manipulation. As a result, financial regulatory authorities decided to phase out LIBOR and replace it with SOFR.

SOFR and Business Borrowers

The shift to SOFR has important implications for business borrowers. While LIBOR rates are forward-looking and include a credit risk component, SOFR is a backward-looking, nearly risk-free rate. As a result, SOFR tends to be lower than LIBOR, which could lead to lower interest costs for borrowers.

However, SOFR is also more volatile than LIBOR. It can fluctuate significantly from day to day, which can increase the uncertainty for borrowers. To mitigate this volatility, lenders may use an averaged SOFR rate over a specific period, such as one month or three months.

Final Thoughts

The transition to SOFR is a complex process that requires careful planning and communication between lenders and borrowers. It’s important for business borrowers to understand how this new benchmark works and how it could impact their borrowing costs. In the end, the goal is to create a more transparent and reliable system for determining interest rates, which can benefit all market participants.