The Fed Funds-SOFR Basis
Fed funds and SOFR are both overnight U.S. dollar rates, but they trade in different markets with different collateral, so the small, usually stable spread between them — the basis — is itself a tradeable and watchable signal.
Fed funds is the rate banks charge each other for uncollateralized overnight loans of reserves held at the Fed, while SOFR is the rate on overnight loans collateralized by Treasury securities in the repo market. Because SOFR is secured by safe collateral, it should logically trade a touch below an unsecured rate like fed funds — lenders demand less compensation when they hold Treasury collateral against a default. In practice the two track closely, and the small gap between them, the fed funds-SOFR basis, reflects differences in who participates in each market: fed funds trading is dominated by a shrinking pool of banks and government-sponsored enterprises, while SOFR reflects a much larger and more diverse repo market.
The basis usually sits within a few basis points but can widen sharply around quarter-ends and other balance-sheet-sensitive dates, when repo funding tightens and SOFR spikes relative to fed funds, or during stress episodes when collateral becomes scarce.
The fed funds-SOFR basis is small and usually stable in normal times, but it widens exactly when funding markets are under stress — making it a useful early gauge of repo market pressure.
If fed funds trades at 5.33% and SOFR briefly jumps to 5.55% around a quarter-end, that 22 basis point widening signals a temporary squeeze in the secured funding market rather than any change in the Fed's target rate.
Practice in interviews
Further reading
- Federal Reserve Bank of New York, SOFR and Fed Funds primers