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Why is SOFR more Volatile than LIBOR

Why is SOFR more Volatile than LIBOR?

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SOFR (Secured Overnight Financing Rate) is more volatile than before because it is an overnight rate. The ARRC (Alternative Reference Rates Committee) determined that it is much safer to collateralize loans and interest rates based on overnight trading instead of utilizing LIBOR (London Interbank Offered Rate) for financial contracts and derivatives. This rate represents the actual cost of interbank lending. Self-reporting aspects of this rate do not exist as they did with LIBOR. 

This eliminates the concern that the rate can be manipulated by member banks and individuals who are more concerned about their bottom line than the consumers who want and deserve protection from fraud and predatory lending practices.

The transition from using LIBOR and converting over to SOFR will not take place overnight because the conversions are not one loan-to-one loan process. The process may cause volatility due to the uncertainty of using a program opposite to LIBOR. In this article will discuss why this is and what is done to mitigate any losses resulting from having a mortgage or other loan based on this benchmark interest rate.

Key Takeaways

  • SOFR is more volatile in the short term because the rate at which banks lend to one another can change, and SOFR looks at the actual costs of lending yesterday, not what it may be tomorrow.
  • Liquidity is the key for many investors, and the changes in the liquidity will move SOFR. Banks put together their balance sheets near the end of each fiscal quarter and ensure that adequate reserves are available.

What is SOFR Interest Rate?

The SOFR (Secured Overnight Funding Rate) is an overnight lending rate based on the most recent data on Treasury repos. It is a spot rate. Long-term loans based on SOFR must have all the data extrapolated to longer maturities. Because of this, SOFR is much more volatile than other IBORs.

Why is SOFR more Volatile than LIBOR?

SOFR is more volatile in the short term because the rate at which banks lend to one another can change, and SOFR looks at the actual costs of lending yesterday, not what it may be tomorrow. The US Treasury repo market allows a borrower to sell a Treasury bond as collateral, and subsequently, the bank repurchases the Treasury the next day to close the loans.

What are the Limitations of SOFR?

There are two major potential pitfalls when SOFR collateralizes loans. One is using actual trades instead of a banker or bank forecasts. This type of securitization can mean more risks than one finds with everyday transactions or contracts. Bankers do NOT like excessive risk exposure.

The second limitation is the fact that SOFR is an overnight rate. Other types of speeds involve a range of maturities and could be based on trading activity from one day to one year. These factors make SOFR sensitive to sudden changes. Once the movement has been stretched over time, the volatility tends to be less than that of other IBORs. The LIBOR is a rate that is quite different from SOFR.

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How is SOFR Different from LIBOR?

There is one glaring difference between SOFR and LIBOR. These transactions have already occurred, affecting rates (SOFR) and the predictions and prognostications of bankers of what may or may not happen on any trading day or trading cycle. Since the bankers already know what happens over the long term, SOFR is a much more reliable rate to determine borrowing rates and other conditions of adjustable rate mortgages. SOFR may appear more volatile because it is an overnight rate.

However, it will outperform LIBOR over time because one cannot manipulate the trade data. There are other reasons why SOFR is more volatile than LIBOR.

Other reasons why the SOFR is more Volatile than the LIBOR

Other reasons for SOFR having more volatility are more market activity and fluctuations. Liquidity is the key for many investors, and the changes in the liquidity will move SOFR. Banks put together their balance sheets near the end of each fiscal quarter and ensure that adequate reserves are available.

Delays in paying corporate taxes, pulling monies from banks and money market funds which can draw money from the reserves in each bank, and when long-term treasury debts were settled. When the treasury debts are, it takes up to 24 hours for the cash to be dispersed. Primary dealers hold this increase in Treasury securities, and consequently, there is a demand for funds. This inversion of the supply and demand forced banks to borrow funds, resulting in a spike in SOFR.

Frequently Asked Questions About The Limitations of the SOFR

On the whole, SOFR is a suitable replacement for LIBOR because the ability for banks or bankers to manipulate the rates, or other key features of the speed, is eliminated.

The difference between SOFR and LIBOR is that the US Treasury and Controller of the Currency have oversight of the securities in SOFR. With LIBOR, there is little to no control because the changes are subject to guesses and predictions. There is sensitivity to market changes and possible manipulation.

Why SOFR is More Volatile Than LIBOR - Conclusion

The volatility, while short-lived with SOFR, is more significant because it is an overnight rate (backward-looking) instead of a banker’s best guess or prediction about the cost of borrowing and lending money at any given time (forward-looking). There will be an adjustment and learning curve when switching which rate and index will be used for adjustable mortgages and loans.

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