The Treasury — SOFR Swap Spread Puzzle Explained

SOFR swap rates have remained below US Treasury rates since October 2018, posing a puzzling arbitrage opportunity because swaps are replicable in repo and bond markets. Traditional explanations for London Interbank Offered Rate (LIBOR)-swap spreads, such as credit risk, no longer apply since Secured Overnight Financing Rate (SOFR) is a nearly riskless rate. This paper builds on existing explanations for swap spreads — such as market frictions, regulations, and collateral effects — using a novel arbitrage-free replication framework in the SOFR setting. We show that observed spreads arise from three factors: bond market price quotes, repo transaction costs, and Basel III regulations.