Capital and collateral may be the metric that supports solvency in both our financial institutions and our clearing houses but seeing what is happening proactively as transactions are conducted is what regulators believe will be the means of truly overseeing the financial system. That first step on the road to transparency seems to be close at hand with the final recommendations for putting forward a global legal entity identification regime set to go before the G20 later this month.
In recent testimony at the US Senate Banking Committee’s hearings on Swaps regulation it was accepted by SEC Chairman Shapiro and CFTC Chairman Gensler, and the Senators on the Committee, that besides capital and collateral to support the risks of swaps transactions, transparency is a critical component of the risk regime. Sen. Schumer asked Chairman Gensler about the transparency issue in the context of the evolving counterparty coding system – the legal entity identifiers.
Transparency is the new mantra of regulatory oversight and the legal entity identifier (the LEI) is the first step on that journey. This very first pillar of global financial reform is a standard for an automated coding scheme for identifying the same financial market participant to each regulator in the same way. With the LEI in place, monitoring pre-defined risk triggers, aggregating risk exposures in an enterprise and across enterprises, and viewing financial transactions in real-time should prove to be a better watch dog than manual discovery efforts or watching capital being depleted.
Chairman Gensler spoke of the LEI initiative as an “international arrangement” referring to the recommendations on such a global system to be placed before the G20 at their Summit in Mexico on June 18-19. The recommendations have been carefully worked through by the Financial Stability Board and were reported on in a posting to their website on June 8th (A Global Legal Entity Identifier for Financial Markets: FSB Report to the G20). The CFTC had separately been seeking to implement such a system for those counterparties in US based swaps transactions.
Chairman Gensler spoke of being close to a decision on the LEI when he said “four parties came in” and that the CFTC “looks like we will pick someone”. What wasn’t mentioned was that the two initiatives, one for the US swaps markets under the CFTC’s jurisdiction and the other, the “international arrangement”, was not yet coordinated, both in time and in approach and needed to be before financial market participants in swaps markets are to be identified with a globally unique and permanent code.
The FSB announcement and their timeline for implementing a global LEI (March, 2013) has apparently put the CFTC’s interim LEI, what they had referred to as the CFTC’s interim compliant identifier (CICI), on hold in deference to the global initiative.
The LEI is a globally unique identifier that will stay with a business entity and its transactions throughout the life of the company. The international regulatory community has not yet settled on how these codes will be set, by whom and what will be its ultimate form. Only its length is known.
The expectation for the LEI was and is for it to be a standardized computer readable code assigned to those businesses that are financial market participants - trading parties in financial contracts, exchanges and others that develop tradable contracts, reference entities in credit default swaps, originators of mortgages, issuers of securities, and all manner of financial intermediaries and financial transaction processors.
Getting agreement on a globally unique and standardized legal entity identifier is the first test of putting a computerized all-knowing-all seeing-capability in place. Without global identification standards it is understood that regulators cannot view systemic risk across the interconnected financial system. That we came this far without having such a global identification system is quite remarkable. It was only by rummaging through the records of the collapsed Lehman Brothers did regulators come to recognize what the industry had known for decades. Regulators had no automated means to aggregate and monitor global risk of the same financial firm or trading counterparty across multiple financial firms.
Transparency accruing to a globally unique LEI when coupled to a similarly Unique Product Identifier (UPI), part of Swaps regulation but yet to be decided, and posted to transactions entered into by counterparties is a powerful risk management tool. The LEI will permit advanced real-time risk management technologies to watch out for danger signs that human eyes are incapable of seeing. Computers would have been capable of aggregating the risk exposures building up in JP Morgan’s hedged positions; aggregating the MF Global repo-to- maturity purchases; observing the absence of Madoff’s alleged positions at the OCC and DTCC; and watching Lehman’s Repo 105 positions moving back and forth between the US and the UK each month end.
With the FSB announcement it is now apparent that the CFTC has a choice, either to wait for the FSB to be more prescriptive as to its implementation objectives or to go forward now with an interim solution for its Swaps counterparties here in the US. The FSBs implementation plan is scheduled to be released this fall with a March 2013 global implementation planned.
Since the CFTC began the qualifying round of the four undisclosed potential designees, one financial market utility which has been public in vying for the designation has been identified as a systemically important financial institution (SIFI). The CFTC could wind up choosing an organization which may not be the ultimate provider of the code. Also, given that the codes format is still open to further definition the CFTC’s interim code selection may not prove to be the permanent one. Either choice could result in the death knell of this effort, and all subsequent attempts at transparency. Financial market participants will not be up for a redo if the CFTC jumped ahead of the global regulatory community on this initiative and a false start at a unique code convention in the US was the result.
The report on the recommendations for organizing the global LEI initiative is now before the G20 for their final word on acceptance. It is a public good and a worthwhile effort that should be supported by all.
Allan D. Grody is President and founder of Financial InterGroup Holdings