Once upon a time, there was Libor, the interbank offered rate in London, which was among the most important benchmarks in the world for setting interest rates on commercial and consumer loans. But multiple scandals, as well as a leading role in the financial collapse of the Great Recession, have inspired efforts to replace Libor around the world.

The Secured Overnight Financing Rate (SOFR) replaces the Libor in the United States. Here’s what you need to know about SOFR, how it differs from Libor, and how you might be impacted by the change.

What is the guaranteed overnight rate?

SOFR is a reference that financial institutions use to price business and consumer loans. The day-to-day financing part of its name refers to the way SOFR sets rates for lenders: it’s based on the rates that large financial institutions pay each other for overnight loans.

“The SOFR is an alternative risk-free rate that will succeed Libor in many US dollar loan agreements, ”said Sam Weller, senior vice president and director of capital markets at Bryn Mawr Trust. “SOFR provides a robust and transparent method for determining a common benchmark rate based on observed and cleared transactions in the market.”

This last part is essential because it separates SOFR from Libor, which is simply based on the rates that financial institutions say they would afford for short-term loans. By taking into account actual inter-institution loan transactions, SOFR will be more reliable than Libor, which has been the subject of insider manipulation, says Weller.

How does SOFR work?

Large financial institutions lend money to each other using Treasury bond buyback agreements, which finance professionals call repos. These repo agreements allow banks to grant overnight loans to meet liquidity and reserve requirements, using treasury bills as collateral. The SOFR includes the weighted averages of the rates charged in these repo transactions.

Since 2019, billions of dollars of SOFR-linked floating rate notes have been issued in the United States, according to Ajay Patel, Thomos S. Goho Chair in Finance at the School of Business at Wake Forest University.

Why are lenders adopting SOFR?

Libor has been one of the main benchmarks for lending since the mid-1980s. However, the history of Libor has been marked by a decline. series of scandals and concerns about inaccuracy due to handling.

“The financial crisis of 2008 and 2009 exposed some of the technical shortcomings of Libor,” Weller said. “Various Libor rate-fixing scandals have made it clear to banking regulators that a more robust and risk-free benchmark is needed to permanently replace Libor. “

These scandals were in part caused or authorized by the contraction of the interbank lending market in recent years, Patel notes. With fewer transactions, he says, the index began to reflect quoted rates, rather than actual transaction rates. And “this self-reported Libor rate may not accurately represent the true cost of borrowing,” Weller notes.

SOFR is much less likely to be manipulated as the Treasury repo market is one of the most liquid markets around the world, which means there is much more actual transaction data to rely on, rather than self-reported hypothetical rates.

“This market averages over $ 1,000 billion a day, which means it reflects actual transactions, not quotes, and cannot be easily manipulated,” Patel said.

SOFR vs Libor: what’s the difference?

As noted above, a key difference between SOFR and Libor is that SOFR is based on completed financial transactions, while Libor is now based on quotes from reporting banks that do not necessarily come from real financial transactions.

However, there are other differences between the two rates.

“One of the main differences between Libor and SOFR is that Libor is forward-looking, while SOFR is forward-looking,” Patel explains. “This means the bank knows the borrowing rate at the start of the period. The SOFR being retrospective, the borrower will not know exactly what he owes until the end of the loan.

Moreover, Patel points out, Libor is unsecured – the loan it is based on does not use collateral – so it includes a credit risk premium. SOFR is a secure rate, based on transactions involving collateral, in the form of Treasury bills, so there is no credit risk premium embedded in the rates.

However, Patel expects some SOFR-based rates to add a credit spread to more closely reflect the need for variable rate product pricing.

Other alternatives to Libor

While SOFR has garnered a lot of attention, it is not the only Libor replacement available. Other Libor alternatives used in the United States or overseas include:

• Average of the overnight sterling index (SONIA). UK, SONIA is expected to replace Libor in 2021. Administered by the Bank of England, SONIA reflects average rates on overnight sterling denominated lending among banks and financial institutions.
• Day-to-day index of federal funds. The federal funds rate is what US banks pay each other for unsecured loans from their reserves held at the Federal Reserve. The index of these rates can also be used to replace Libor by some lenders.
• Ameribor. Created by the American Financial Exchange (AFX), Ameribor is an index based on the unsecured borrowing costs of small and medium-sized banks in the United States. The information is stored through the blockchain and an index is created using a credit-weighted average of the relevant unsecured loans.
• US prime rate. The preferential rate has been used for years as a benchmark for credit card tuning, home equity line of credit and other APRs. The prime rate is based, in part, on the federal funds rate.

What does SOFR mean to you?

According to Patel, few consumers are expected to notice an impact when switching from Libor to SOFR. The change will primarily affect financial institutions, although if you look at loan interest rates you may find that they are now calculated on the basis of SOFR, rather than Libor.

Although the switch from Libor to SOFR has already started, it may take years for the switch to be complete.

“Borrowers who are considering adjustable rate mortgages are already seeing SOFR prices, and this trend will continue for other types of adjustable rate consumer products,” Weller said. “Financial institutions have been preparing for this Libor-SOFR transition for years. “

That said, it will still take some time for the current Libor borrowing arrangements to work in the system. As a result, existing contracts will always be part of the landscape for years to come.

“The transition from Libor to SOFR represents a huge change in the plumbing of the global financial system,” says Weller. “While we haven’t quite seen the end of Libor, it will certainly become less visible in the years to come. “

To view current SOFR rates, visit the New York Federal Reserve website website. The New York Fed is the administrator of SOFR’s calculations and publishes the rate daily.