If we had a legal entity identifier in place could we have seen the problem building up? The short answer is yes.
At this week's U.S. Senate Banking Committee hearings on Swaps regulation both SEC Chairman Schapiro and CFTC Chairman Gensler were asked when and how they became aware of JPMorgan Chase's (JPM) hedging difficulties. They both answered they first heard about it through the media. Revelations from the financial crisis taught us that regulators did not have the tools to see into the financial institutions they were charged with overseeing. Obviously we haven't fixed that problem yet. But there is hope that a global initiative known as the legal entity identifier project will.
The LEI is at the beginning of a long chain of regulatory initiatives to monitor financial institutions through the transactions they engage in and the risk exposures they engender. The 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. Getting agreement on a globally unique and standardized legal entity identifier is the first test of putting this computerized all-knowing-all seeing-capability in place. The G20’s Financial Stability Board, an entity with a broad charter to risk adjust the financial system has begun laying the foundation for such a regulatory capability.
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.
The transparency of a globally unique LEI posted to transactions entered into by counterparties is a powerful tool. The LEI will permit advanced real-time risk management technologies to watch out for danger signs that human eyes are incapable of seeing. With the LEI in place computers would have been capable of aggregating the risk exposures building up in JPMorgan's hedged positions and across its many counterparties.
The expectation for the LEI is for it to be a standardized computer readable code assigned to those businesses that are financial market participants — issuers of securities, trading parties in financial contracts, exchanges and others that develop tradable contracts, reference entities in credit default swaps, originators of mortgages, and all manner of financial intermediaries and financial transaction processors.
The idea of the LEI became part of the new rules of the Dodd-Frank Act. The LEI and the unique product identifier became subject of solicitations of interest by the U.S. Treasury's new Office of Financial Research, the CFTC and the SEC in late 2010. A later solicitation, by the Committee on Payment and Settlement Systems of the BIS and IOSCO, the global securities' regulators organization, ending in late September of this past year, resulted in further views on what was required to implement the global LEI.
Coming up with a global numbering convention acceptable to vendors, practitioners and regulators alike is not easy. Having it persist through all changes in ownership and corporate events makes it even harder. Becoming the lynchpin of financial reform as well as the transformational element in risk adjusting the financial system is harder still, but is its ultimate goal.
The FSB organized two panels, an Expert Regulatory Group and an Industry Advisory Panel. They convened in Basel, Switzerland at the end of March, 2012, joined by industry experts and thought leaders, some 120 representatives in all. They were there to discuss the LEI in the context of rethinking the original requirements developed from the U.S.-centric perspective. The approaches developed back then had taken a global view for sure, but without defining global regulators’ requirements nor appreciating approaches taken in other industries. The countries and financial institutions now opining on the LEI are reflecting on the role their own business registries play in accommodating local business entity identification and their hierarchies of ownership and how that can be mapped into a global LEI solution.
All the constituent groups seem to be around the table now, including the most important stakeholder group, non-financial market participants — corporate users of derivatives, security and debt issuing main street corporations, and sponsors of pension funds to name but a few who will have to self-register their own LEIs.
Seeing what is happening through monitoring 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 then past manual efforts. It should augment the forensic approaches taken by bank examiners, the look back into loss history conducted by capital adequacy regulators, and the audits conducted around past transactional events. It will certainly be an improvement over regulators depending on the evening news for signs of financial blowups!
Allan D. Grody is the president of Financial Intergroup Holdings Ltd.