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Despite volatility, Goldman sees Sofr as new benchmark in post-Libor world

U.S. financial institutions will move away from the London Interbank Offered Rate in just a few years, and Goldman Sachs Group Inc. still sees the group adopting the Secured Overnight Financing Rate, or Sofr, despite recent volatility in the relatively new benchmark.

Responding to manipulation of the benchmark, U.K. regulators will force the retirement of Libor, a rate tied to nearly $400 trillion in financial contracts, by year-end 2021. The U.S., the U.K. and Europe have created new benchmarks driven by transaction activity in the market. Libor is calculated from estimates that major banks submit in a survey.

In the U.S., the Federal Reserve convened a committee in 2014 to develop a new reference rate. Nearly three years later, they unveiled Sofr, which measures the cost of borrowing cash overnight, collateralized by Treasurys. That rate recently jumped several hundred basis points with volatility in the short-term borrowing markets in mid-September.

While the move certainly received plenty of attention and sparked a series of questions from market participants, the shift in the benchmark rate was not a cause for great concern, Jason Granet, head of Libor transition for Goldman Sachs, said in the latest Street Talk podcast.

In the episode, Granet discussed how prepared the banking industry is to transition away from Libor, what Goldman Sachs is doing today ahead of the move and how the recent volatility in Sofr does not change its status as the true replacement for Libor in the U.S., even over some alternative benchmarks.

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Granet noted that Sofr remained a liquid market during the recent volatility, whereas interbank lending that institutions use to create Libor has declined significantly since the financial crisis due to new liquidity regulations and changes in balance sheet structure.

Granet further noted that the mathematical impact of the short-term jump in Sofr was smaller than historical moves in Libor. For instance, he noted that an intraday increase of a couple hundred basis points in Sofr might result only in a 2-basis-point change in the benchmark used by institutions since the rate often will be based on the average rate over three months. Meanwhile, Libor has increased 4 to 6 basis points multiple times overnight, he said.

"I actually think the bout of volatility showed the value and health of referencing Sofr. People are just going to have to understand that there's going to be real market events," Granet said in the episode. "Mathematically, it was less impactful and probably more robust."

Granet further noted that he does not see some of the alternative benchmark rates that have surfaced as potential Libor replacements emerging as a standard rate for the industry. He noted that global regulators have laid a path for the derivatives market to migrate to central bank-produced reference rates such as Sofr in the U.S. He said the derivatives market accordingly would likely move to those rates. He further noted that the Financial Accounting Standards Board has approved Sofr as a hedge accounting rate.

"When you have hedge accounting and derivatives and some of the key things that are out there already linked to Sofr, I think it's going to be hard for any other rate to really get any meaningfully substantial dent of market share," Granet said. "That being said, will certain organizations reference certain rates to do certain activities? Yeah, of course."

Granet encouraged institutions to spend considerable time preparing for the Libor transition, working on infrastructure, legal contracts, and updating systems and models. He said institutions need to be ready to absorb when liquidity migrates toward the new reference rate since that could occur before Libor is retired.

"When liquidity starts to substantially move, that's when it really starts to matter. If liquidity moves three, six, 12 months before that date and you're not ready, that's clearly not the place you want to be," Granet said in the episode.