The Foxes that Guarded the Henhouse

June 21, 2021

Author: Guy Soreq

The financial world will begin what some are calling a once-in-a-lifetime transition this year, and the team at Glowlit is here to learn from it. The London Interbank Offered Rate (LIBOR) will be phased out beginning in December of this year, with the final stage of the process set to be completed in June 2023. This transition follows a major scandal surrounding LIBOR that came to light in 2012, though there is evidence of collusion dating back to 2003.

Since the mid-1980’s, LIBOR has served as the globally accepted interest rate benchmark indicating borrowing costs between banks. It is used in pricing interest rates related to debt and derivative contracts. But LIBOR doesn’t only affect banks - it is the basis for loans all over the world impacting consumers just as much as it does financial institutions. Odds are that the interest rate for your credit card, car loan, or mortgage has been set using LIBOR.

LIBOR is set using reference interest rates submitted by a self-selected and self-policing group of the world’s largest banks. Each morning these banks report a number, largely based on conjecture, and an average is then published mid-day. Until more recently, the banks’ individual submissions were also published along with the average. The system, which relied on self-reporting the truth, failed miserably.

You’ve probably heard of a few of the banks implicated in the LIBOR scandal - they include Deutsche Bank, Barclays, Citigroup, JPMorgan Chase, the Royal Bank of Scotland, and UBS. Traders at many of these banks submitted falsely inflated or deflated rates in order to maximize their profits from trades. In the wake of the 2008 Financial Crisis, banks manipulated their rates in order to give the false impression of creditworthiness to ensure access to the liquidity they so desperately needed. With LIBOR so deeply embedded in our global financial system, the impact of the scandal sent shockwaves throughout the world.

So what can we learn from the last two decades of LIBOR drama? The Glowlit team has a few important takeaways.

  1. The right balance between anonymity and transparency is key. When the 2008 Financial Crisis hit, banks were incentivized to report rates that allowed them to remain creditworthy. How did they do that? They simply looked at the rates published by peer institutions contributing to LIBOR, and maintained positions in the middle of the pack to not attract undue attention. Only after the intense scrutiny that followed the scandal were individual submissions moved to being published months after the LIBOR rate.
  2. Benchmarks require a large enough sample size. After the highest and lowest numbers are taken out of the equation, LIBOR is calculated from rates reported by 5 to 8 contributors. For the dollar alone, LIBOR is used to determine interest rates on $223 Trillion of debt and derivatives. That’s more than 2.5 times annual global GDP tied to a benchmark determined by only 8 submissions. While I can’t tell you what the right number should be, I can definitely say that it isn’t 8.
  3. Judgement in the absence of data leaves a lot of room for manipulation. During the financial crisis, interbank borrowing slowed to a halt, leaving even less information to judge the accuracy of rate predictions. In the absence of data, even the banks which tried to report honestly submitted overly optimistic guesses. Those less intent on honest reporting had a great deal of room for creative reporting. The systems coming to replace LIBOR are considered more reliable because they are based on actual transaction rates, rather than the hypothetical guesswork surrounding LIBOR.

So what does all this have to do with Glowlit? A lot, actually. We thought a great deal about the lessons from the LIBOR scandal when we designed and developed the Glowlit platform. Striking the right balance between anonymity and transparency has always been of critical importance to us. We maintain user anonymity to ensure that our system contributes to - rather than detracts from - the competitiveness of individual companies and thus our industry at large. At the same time, we offer a window of transparency into the sample size for every single price point.

We also believe in the power of the crowd over the few. Glowlit users represent the entire supply chain, from the smallest feed mill to the largest producer. We believe that everyone has valuable data to contribute, and we take pride in our ability to attract users from the more fragmented demand side of the supply chain.

And lastly, we started Glowlit as a way to gather objective data in a market intelligence industry filled with more subjective reporting. Even the best intentioned reporting can be skewed by conjecture and human error. In the case of the LIBOR scandal, we saw the most extreme side of this. That is why Glowlit relies on a system of hybrid verification, utilizing both artificial intelligence and our own Verification Team to conduct market research.

The world will have relied on LIBOR for nearly four decades at its conclusion later this year. Several front runners have emerged as alternatives to LIBOR, all intending to correct the mistakes of the past. While they are bound to come with their own sets of challenges, we hope that they will internalize what may be the biggest takeaway of all: when it comes to guarding the global financial henhouse, next time let’s not leave it to the foxes.