The SOFR rate is fundamental to the U.S. financial system and is used, among other things, to settle trillions of dollars of margin positions in derivatives and swap transactions. It also plays a role in interbank lending and credit agreements and serves as the benchmark for determining the cost of corporate lending.
SOFR vs. LIBOR
Unlike the manipulative LIBOR rate, SOFR is based on real transactions, with a daily trading volume ranging from 1.4 trillion to 2 trillion dollars.
The RRR rate, which represents what the Federal Reserve pays to banks and funds for excess liquidity placed on the Fed's books, currently stands at 5.3% after the Fed increased the upper range of the key rate to 5.5%.
Normally, the spread between SOFR and RRR is 1 to 2 basis points (bps), but it widened to 8 or even 10 bps in early 2024. A significant premium of SOFR over RRR indicates a liquidity deficit or structural imbalance in the U.S. dollar financial system.
The Role of Standing Repo Rate (SRF)
To address this problem, there is a standing repo rate, or SRF, which is quoted at 5.5% and is used in case of liquidity shortages. The largest deviation on the SOFR was 5.4%. While this may seem insignificant (the SRF mechanism has not yet been activated), given the size of the market, even a very small deviation can have significant implications for the system.
The Historical Perspective
This scenario occurred in 2019 when the Fed initiated early liquidity measures and started easing the SRF.
As of the morning of January 17, SRF operations had fallen to 583 billion dollars, the lowest level since June 14, 2021, compared to an average of 2.2 trillion dollars in April - June 2023. By comparison, it stood at nearly 1.4 trillion dollars in early October 2023.
Excess liquidity is evaporating due to Quantitative Tightening (QT), even with backlogs and record placements of Treasury bonds, and is expected to reach zero by April 2024.
Conclusion
In summary, SOFR is vital to the U.S. financial system, driven by real transactions, with a wide range of applications. The widening gap between SOFR and RRR in early 2024 highlights potential liquidity issues, prompting the use of the standing repo rate (SRF). Excess liquidity is diminishing due to Quantitative Tightening (QT), posing ongoing challenges for the financial landscape.