Alternative Reference Rates Committee: SOFR Starter Kit Part II (also see Part I and Part III)

How SOFR Works

In 2017, the ARRC selected the Secured Overnight Financing Rate (SOFR) as its preferred alternative to U.S. dollar (USD) LIBOR. SOFR is a broad
measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities in the repurchase agreement (repo) market. (See SOFR
Starter Kit Part I for more on the selection of SOFR.)

SOFR has several characteristics that make it much safer and less vulnerable to manipulation than LIBOR, including that it:
• Is based on an active underlying market with a diverse set of borrowers and lenders;
• Is based entirely on transactions (not estimates); FICC Members Eligible to Transact in the Repo
• Is produced in compliance with international best practices; and Market
• Covers multiple market segments, ensuring robust transaction volumes in a wide range of market conditions.
Includes:
• Independent
Repo Market Overview Repo Market Participants Dealers
• Brokers
• Government Other
SOFR reflects transactions in the Treasury repo market. There are a wide range of financial market participants directly GSIBs
Repos are conceptually straightforward. They effectively Sponsored 39%
involved in the Treasury repo market, including asset managers, 33%
are collateralized loans, in many ways similar to mortgages Enterprises
banks, broker-dealers, corporate treasurers, insurance companies,
in which homeowners borrow money using their homes as money market funds, pension funds, and securities lending agents.
collateral. In the Treasury repo market, people borrow
money using Treasury debt as collateral. To understand the diversity of institutions involved in the Treasury
repo market, consider the segment of the repo market involving the
Fixed Income Clearing Corporation (FICC). Non-GSIB
• In 2020, FICC has accounted for only 60% of SOFR’s roughly Banks
Reason for Borrowing “Secured” Funds $1 trillion in daily transaction volume. That segment alone 28%
involves roughly 2,000 institutions through its members and
When a borrower “secures” a loan with collateral, the “sponsored memberships” who are able to transact in the
lender has more options to get repaid. After all, if the Treasury repo market with FICC. Source: Fixed Income Clearing Corporation; New York Fed calculations
borrower fails to repay the loan, the lender is able to
take possession of the collateral and sell it to recover Beyond the diverse entities that regularly transact directly in the Chart above reflects segmentation of FICC members. FICC
the funds lent. repo market, there is a significant number of entities with indirect members affiliated with 79 different “parent entities,” are
exposure to the Treasury repo market. eligible to transact in the segments of the repo market where
Lenders are therefore typically more willing to make • For example, any investor in the $4.5 trillion money market fund FICC serves as central counterparty.
“secured” loans—like repos—than unsecured loans, industry likely has exposure to the repo market. Similarly,
where the lender does not have the benefit of collateral pension funds—like the California Public Employees’ Two-thirds of those parent entities include non-GSIB banks,
to guarantee payment. Retirement System, which serves over two million members in non-bank affiliated securities dealers, and government
the retirement system—typically lend cash in the repo market.
sponsored enterprises.
Alternative Reference Rates Committee
How SOFR Works – Q&A

Q: What sort of financial products are Q: Of the many rates evaluated, why did
Q: What makes SOFR a robust rate?
expected to reference SOFR? the ARRC ultimately select SOFR?

A: SOFR is a fully transaction-based rate A: Moving the financial system off of LIBOR is a
A: SOFR is suitable for use across a broad
reflecting roughly $1 trillion of daily transactions very challenging and costly process, so it was
range of financial products, including derivatives
in a market with a diverse set of borrowers and extremely important to the ARRC to avoid the need
and many cash products that historically
lenders. This is much larger than the transaction for another transition in the future. In identifying its
referenced USD LIBOR.
volumes in any other U.S. money market and recommended alternative to USD LIBOR, the
dwarfs the volumes underlying LIBOR. It is ARRC looked for a rate that met its selection
Q: What should market participants do criteria including robustness, governance, ease of
produced by the New York Fed with a
methodology and governance structure now to transition to SOFR? use and quality. (See SOFR Starter Kit Part I for
consistent with international best practices. more on the selection of SOFR)
These factors make SOFR a reliable A: As ARRC Chair Tom Wipf often says: “The
representation of conditions in the overnight first step to get out of a hole is to stop digging.” In addition to meeting those standards, SOFR
Treasury repo market – reflecting lending and Consistent with his advice, the ARRC stood out for having the most underlying
borrowing activity by a wide array of market recommends writing new contracts based on transactions. It is also the broadest measure of the
participants, including asset managers, banks, SOFR whenever possible, and provides a range market it covers, making it best placed to remain
broker-dealers, insurance companies, money of tools to support market participants robust even if its underlying market evolves. That
market funds, pension funds, and securities transitioning to SOFR, including recommended market – the Treasury repo market – is very
lenders. Best Practices and the User’s Guide to SOFR. durable, since the ARRC expects it to exist as long
For contracts that still need to reference USD as the U.S. Treasury is issuing debt.
LIBOR, the ARRC recommends incorporating
language so that those contracts fall back to With these factors in mind, SOFR is the most
SOFR when LIBOR inevitably becomes resilient option and it is the most likely rate to
unusable. (See SOFR Starter Kit Part III for more ensure we will not have to go through this process
ARRC transition tools). again.
Alternative Reference Rates Committee
SOFR by the Numbers

~$1 trillion
The transaction volume underlying SOFR
averages around $1 trillion per day. This is
far greater than the volumes underlying
overnight unsecured rates, and, while not a
direct comparison, dwarfs the volumes
underlying term unsecured rates—such as
the ~$500 million estimated to underlie
3-month USD LIBOR.

300+ 2021
The ARRC has 300+ diverse private- After December 31, 2021, market
market institutions and associations participants should assume LIBOR will not
involved on its working groups, continue. The ARRC encourages market
supporting the transition to SOFR, participants to continue to adopt SOFR in a
its preferred alternative to USD LIBOR. range of financial contracts and incorporate
SOFR fallback language if they enter new
LIBOR-referencing contracts.
Alternative Reference Rates Committee
Common Misconceptions of SOFR

Misconception 1: SOFR is more volatile than LIBOR.

SOFR is based entirely on actual transactions. As a robust, well-designed reference rate, it accurately reflects conditions in the market it was created to represent. The ARRC picked SOFR fully aware
that transaction-based rates may be volatile if market conditions become volatile. Variability in SOFR is not an issue for its use as an alternative to USD LIBOR since almost all contracts referencing
SOFR will rely on averages of daily rates. These averages are relatively stable and can be easily referenced in financial contracts, as demonstrated by the growing use of SOFR in futures, swaps
and floating-rate debt. In fact, a three-month average of SOFR has been less volatile than three-month USD LIBOR over a range of market conditions.

Misconception 2: Market participants should wait for a forward-looking SOFR term rate before moving to SOFR.
While it is true that a forward-looking SOFR term rate may be appropriate for a limited set of contracts, the growth in SOFR-linked futures, swaps, and floating-rate debt demonstrates the current
viability of using SOFR itself in a wide range of financial contracts. A robust forward-looking term rate requires a deep, active SOFR derivatives market, which requires most financial contracts to
reference SOFR itself. It is essential that most financial contracts reference SOFR itself as soon as possible, in order to develop a forward-looking SOFR term rate, and in turn facilitate a
smooth transition. Since March 2020, the New York Fed has been publishing SOFR Averages for several tenors and an index to calculate SOFR rates over custom time periods. These provide a
transparent and reliable source that market participants can use to start building new SOFR-linked contracts now. As there is currently not sufficient underlying futures activity to support a robust term
rate and no assurance that one will be produced ahead of LIBOR becoming unusable, those who are able to use SOFR should not wait for forward-looking rates in order to transition away from LIBOR.

Misconception 3: SOFR is not appropriate for all market participants.

After more than two years of transparent research and public consultation, the ARRC determined that SOFR is the most suitable alternative rate for institutions of all sizes and products of all
types. It’s a robust rate that can be used in a wide variety of products, including loans, and it’s available now. The ARRC supports a vibrant and innovative market with reference rates that are robust,
consistent with international best practices, and available for use before the end of 2021. The ARRC’s recommendations have always been voluntary and it recognizes that market participants may
choose other rates, but any solution must be robust.

Misconception 4: Transitioning to SOFR is less urgent due to the COVID-19 pandemic.

Key financial regulators, including the regulator of LIBOR, have made it clear that market participants should continue to assume they cannot rely on LIBOR being published after the end
of 2021. Thus, it is important that market participants continue to prepare for LIBOR becoming unusable after 2021. While the ARRC recognizes that certain near-term, interim steps in the transition
may be delayed given the current economic environment, the financial system must continue to transition away from LIBOR – and, ideally, toward SOFR.