The Dodd-Frank Act charters a new Office of Financial Research to provide input to the Financial Stability Oversight Council on the vulnerability of the U.S. economy to systemic threats.
The current set of rulemaking activities by the OFR, the Securities and Exchange Commission and the Commodity Futures Trading Commission calls for standards for an underlying identification system for financial transactions. These standard identifiers for both products and the business entities that own them would allow for institutions and market utilities to report position and transaction data to the OFR in a standard way. This is to be done so that the OFR can aggregate data across multiple entities and in turn analyze risk building up in the interconnected financial system.
Late last year the OFR, part of the Treasury Department, posted its notice on legal entity identification. This and similar notices by the SEC, the CFTC, and the Federal Reserve prescribed initial principles for business entity identifiers, Swaps uniform identity codes and myriad unique product identifiers and transaction codes.
Collectively these releases make numerous references to preferences for universal, unique and unambiguous identifiers and data standards; refer to an industry consensus process in deciding on such reference data; speak about international recognized standards bodies taking on this job as a not-for-profit public good; and discuss the possibility of financial firms eliminating the use of multiple proprietary reference systems and moving to a single, widely accepted global system.
The financial industry does not have unique, unambiguous and universal identifiers for its products and counterparties. This results in transactions that are agreed to by two parties under specific terms and conditions not being able to be paid for because their agents have different identifiers and data attributes defining what should be identical terms and conditions. The current three-day grace period in the U.S. before you have to pay for securities you bought is, in part, a recognition of data faults that have to be reconciled before payment can be affected.
This lack of data standards also prevents regulators from obtaining a global view of the underlying positions for valuation and aggregation purposes in order to detect systemic threats. Additionally, systemic risk is a global phenomenon, and needs to be measured by multiple global regulators across multiple financial firms. Systemic risk cannot be dealt with from regulatory silos. The OFR's hope is to implement this regime across the globe through cooperating regulatory bodies. Here its ambitions might best be accommodated through the G-20, allowing for a federated model of self-registration administered by a global standards administrator.
The G-20's Financial Stability Board has already been assigned the global responsibility of creating a systemic-risk analysis framework not unlike the Bank for International Settlements oversight of the Basel global capital standard. The Basel regime respects sovereign regulation while providing the framework for common standards implemented by each regulator. It may be the best model for transcending regulatory silos.
Most global industries have already invested in universal identification to uniquely identify their products, transportation intermediaries, product manufacturers and trade counterparties. This helped regulators track a tainted Tylenol capsule back to its manufacturing process and find the source of tainted cow meat across the globe. However, financial regulators could not find the source of the defaulting mortgages in a toxic collateralized mortgage pool nor see the counterparty positions allegedly held by the convicted financial con artist Bernard Madoff at a London OTC options dealer.
The OFR and now industry trade associations are calling for a self-registration process whereby issuers and originators of financial instruments and financial contracts obtain their own set of unique numbers. No firm could participate in financial markets nor issue a new financial product without getting a universal code first. Look at any bar-coded product in any supermarket across the world and you'll see the simplicity of such a system.
