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 LIBOR-swap spreads, such as credit risk, no longer apply since 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.