Introduction

The Secured Overnight Financing Rate (SOFR) has become an essential benchmark for global finance, especially in the US, affecting financial markets globally, even in India. Investors, Businesses and Financial professionals in India interested in international trade or investment will benefit from understanding what SOFR means. This article discusses the SOFR meaning, how it works, and its historical context, with a particular emphasis on relevance to the ecosystem in India.

What is SOFR? Understanding the meaning and definition

The SOFR complete form is Secured Overnight Financing Rate, a benchmark interest rate that reflects the cost of borrowing cash overnight in the US, secured against U.S Treasury securities. The SOFR is not a traditional rate derived from estimates made by banks. Still, it is determined by actual transactions in the repurchase agreement (repo) market, where market participants borrow cash by pledging government securities to lenders as security/collateral. This means the SOFR rate is transparent, reliable, and practically impossible to manipulate, avoiding the flaws of the benchmark interest rate, the London Interbank Offered Rate (LIBOR).

SOFR's significance for India is not only a benchmark for monetary policy, but also because it propagates to a global marketplace that includes financial instruments (derivatives, loans, bonds, etc.) that Indian banks, corporations, and investors often participate in. For example, when Indian companies lose dollar-denominated loans or invest in U.S. financial markets, they extract a SOFR interest rate in the loan contracts and risk assessments, which impact borrowing costs and expected returns on investment.

How Does SOFR Work? A Transparent Benchmark

The SOFR rate is calculated every day by the Federal Reserve Bank of New York, which uses transactions in the U.S. repo market which trade over $1 trillion a day to compile the SOFR rate. The SOFR calculation is based on data from three broad categories of the U.S. repo market. The three categories are the Tri-Party General Collateral Rate, Broad General Collateral Rate, and bilateral repos transacted through the Fixed Income Clearing Corporation.

While SOFR is internationally relevant for cross-border finance, India has a specific domestic benchmark in MIBOR. Many banks operating in India, like State Bank of India or ICICI Bank, use dollar-based lending contracts or develop hedges in foreign currency derivatives referencing SOFR interest rates. When two foreign counterparts engage in trade based on dollar lending/borrowing in the U.S., SOFR is relevant for Indian exporters or importers. A floating-rate trade finance loan based on SOFR or an interest rate swap referencing SOFR will impact trade financing costs.

SOFR in Historical Context

The story of SOFR begins when LIBOR, an international benchmark, was deemed unreliable due to scandals and fundamental flaws in its structure. LIBOR is based on estimates made by banks of the interest rate at which they would borrow funds from other banks in an interbank loan. Many market participants did not trust the rate through the 2008 financial crisis, as banks manipulated quotes submitted, essentially eroding the integrity of the rate. By 2014, global regulators, including the U.S. Federal Reserve, searched for a more reliable alternative. The Federal Reserve, through the Alternative Reference Rates Committee (ARRC), which was formed in 2014, selected SOFR as the benchmark to replace LIBOR due to its inherently reliable transaction-based calculations and its conformance to the U.S. Treasury repo market, which is deep and liquid.

In 2018, the New York Fed started publishing the SOFR rate, marking a watershed moment in the SOFR's evolution. It was closing time for LIBOR, and the transition was aided by an expected termination date of June 2023 for most LIBOR-linked contracts in the U.S. The transition to SOFR was difficult as the market had to think differently about SOFR than LIBOR (i.e., LIBOR included bank credit risk while SOFR has none). The ARRC put spread adjustments in place along with term SOFR rates to make the transition rational for market participants, while still allowing them to maintain consistency with prior financial products.

For India, the SOFR history will be tied into global financial reform. Regulators, like the Reserve Bank of India (RBI), have encouraged banks to shift their dollar transactions toward SOFR to ensure no deviation from accepted international norms. Concerning Indian firms, those engaged in U.S. markets (like the IT giants Infosys or the Pharma sites like Dr. Reddy's Pharma) are converting their dollar loans and derivatives to SOFR. The move reduces the risk of LIBOR's phase-out.

Why SOFR Matters to India

The Secured Overnight Financing Rate is not a U.S.-only benchmark and has worldwide ramifications. Indian companies' experiences in international capital markets include encountering SOFR in syndications, trade finance, and hedging instruments. For instance, consider an Indian company issuing a dollar bond: potential interest payments may occur below the SOFR rate and affect their margins. Likewise, Indian investors holding U.S. mutual funds, exchange-traded funds, or other assets linked to SOFR should be aware of SOFR's possible impact on results.

While SOFR's transparency is an advantage to Indian financial institutions as protection from another rate manipulation by lending and industry organisations, increasing trustworthiness across non-U.S. markets, some of the challenges in adopting SOFR remain.

Conclusion

To sum it up, the Secured Overnight Financing Rate (SOFR) represents a paradigm shift in global finance through a stable, reliable, transaction-based benchmark. Its history reflects practical lessons from prior failures. At the same time, its meaning for India lies as a stable, reliable reference rate applicable for global cross-border transactions when both parties reside in the US and India, respectively, moving forward along SOFR's trajectory. Ultimately, businesses and investors in India can be shaped by SOFR substances and referred to SOFR services as they progress through the new phase of navigating financial decision-making processes in India with ever-growing courses of action in mind.