Why USD Swap Discounting Shifted from Fed Funds to SOFR
Summary
The discussion explains the market rationale for moving cleared US dollar swap discounting from the Effective Federal Funds Rate curve to SOFR. The accepted answer links the transition to the broader effort to replace LIBOR, whose survey-based construction had been vulnerable to manipulation. SOFR was selected as an alternative because it is based on a larger volume of overnight Treasury repo transactions than the federal funds market.
The answer says that shifting discounting for cleared swaps was intended to encourage liquidity in longer-dated SOFR derivatives, even though federal funds swaps were then more liquid. A second response qualifies the premise that banks primarily fund through federal funds, noting structural changes after the financial crisis and the role of repo and term funding. The exchange offers historical rationale rather than a detailed valuation analysis, and its market conditions and scheduled transition timing reflect the period discussed.
Key ideas
- SOFR was selected as a LIBOR replacement because its underlying repo market had greater transaction volume than the federal funds market.
- LIBOR’s poll-based construction was considered vulnerable to manipulation.
- Changing cleared swap discounting was intended to support liquidity in SOFR derivatives.
- Bank funding includes repo and term funding, so federal funds activity alone may not represent it.
- The discussion gives historical context rather than a full quantitative comparison of curves.
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# Replacing USD OIS discounting based on FED Funds Rate with SOFR discounting # Replacing USD OIS discounting based on FED Funds Rate with SOFR discounting Slightly related to my other question (The exact mechanics of USD OIS Swaps: replacement of USD Libor by SOFR) but nonetheless, this is a separate topic: US banks fund themselves via EFFR (Effective Federal Funds Rate), as well as the Secured Overnight Financing Rate (SOFR). There are OIS swaps on both rates, albeit the EFFR OIS swaps are much more liquid (at the moment): as per the answers to my other question. Does anyone understand why the FED, alongside ISDA, decided to - going forward - drive a shift from EFFR OIS discounting to SOFR OIS discounting? The fact that EFFR OIS swaps tend to be much more liquid tells us that banks utilize funding via EFFR more than via SOFR. Why would the FED (and ISDA) encourage a shift in discounting towards a less liquid curve? Intuitively, I cannot really make sense of it: it would only make sense to me as a "marketing" or "political" move in an attempt to make SOFR a more prominent rate (as part of LIBOR cessation). ## Answer by dm63 (score 3, accepted) https://quant.stackexchange.com/a/58373 The Fed convened the ARRC (Alternative Reference Rate Committee) in I think 2015 to begin the process of transitioning the financial markets away from Libor. Why? Because Libor had been manipulated , on account of the fact it was based on a poll rather than being sampled from a large , liquid market. The Committee, whose minutes are public, selected SOFR as a replacement rate. Why did they select SoFR instead of EFFR? Because the volume of overnight Treasury repo transactions that are the basis of SOFR far exceeds the volume of overnight Fed Funds transactions, which are overnight loans of funds between banks. Having selected SOFR as the replacement rate , the Fed wanted to encourage the development of liquidity in longer dated derivative transactions based on the rate. One way of doing this is to change the discounting rate of cleared Swaps to SOFR instead of EFFR. Hence the main exchanges including the CME obliged and the change in discount rate is scheduled for mid October 2020. ## Answer by user42108 (score 2) https://quant.stackexchange.com/a/58365 "US banks fund themselves via EFFR (Effective Federal Funds Rate), as well as the Secured Overnight Financing Rate (SOFR)" Bank funding is only partly via Fed Funds - there were many important structural changes to that market post-GFC which I believe reduced bank participation in the market. See, for example, this paper: https://www.clevelandfed.org/en/newsroom-and-events/publications/economic-commentary/2017-economic-commentaries/ec-201707-the-federal-funds-market-since-the-financial-crisis.aspx Perhaps more representative to say banks fund via repo but only a fraction of that is overnight. Funding desks will want to have a significant portion of their funding via term rather than O/N.
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