U.S. regulators are thinking through a just-passed initiative of the Group of 20 major economies that requires all regulators to adhere to a universal standard for identifying through a common code each contract market participants.
The Commodity Futures Trading Commission has a more immediate need for something called a Legal Entity Identifier in its just-passed swaps regulations. But the CFTC's LEI may not mesh with the G20's global initiative of the same name and intent. The difficulty is mired in implementation timing differences and technical details that are now surfacing.
One of the lynchpins of U.S.-initiated financial reform was to regulate the over-the-counter derivatives markets and attract the commitment of other sovereign regulators in support of a common purpose, as described throughout the Dodd-Frank legislation. But without a global regulator, the only way to make this work is in the form of best practices, fostered through global consensus and administered locally by sovereign regulators.
The Financial Stability Board, a creation of the G20, has stepped up to the task. Last month at a summit in Los Cabos, Mexico, the G20 approved the FSB's recommendations for a global LEI system – a system for identifying all financial market participants and the products they own, trade and process, starting with swaps. This is to be the very first step on a long but necessary journey toward bringing transparency to financial transactions and risk-adjusting the financial system. The FSB is readying a March 2013 implementation.
It was not surprising that the Securities Industry and Financial Markets Association, a U.S.-led trade group, focused on a U.S.-centric solution when only U.S. regulators were focusing on the LEI. SIFMA recommended a group led by the financial industry's own financial market utilities: the New York-based Depository Trust and Clearing Corp. and the Brussels-based Society for Worldwide Interbank Financial Telecommunications. The trade group proposed a centralized solution in which the world's financial market participants would request a code and leave sensitive data with the DTCC. No regulator would be involved, other than U.S. ones, even though regulators throughout the world have traditionally been the keepers of these codes, usually in business registries kept separately and in non-standard form within each sovereign jurisdiction.
However, things have changed since U.S. lawmakers conceived the LEI. The G20 has accepted the FSB's recommendations that sovereign regulators, each within its own jurisdiction, are to control the issuance and management of the LEI registries. In May, the FSB rejected SWIFT as the global registration authority for the LEI, in favor of local registrants, and more recently U.S. regulators stamped the DTCC with the scarlet letters "SIFI" – a Systemically Important Financial Institution, subject to being broken up if stress in the financial system indicates such preventive action is warranted. Not a comfortable place for regulators to house its "flashlight" on the financial industry!
It is widely understood that without global identification standards, 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. Only by rummaging through the records of the collapsed Lehman Brothers did regulators come to recognize what the industry had known for nearly a quarter century: Regulators had no automated means to aggregate and monitor global financial transactions of the same financial firms or trading counterparty across the financial system for observing the risks a firm was exposed to.
The LEI is expected to be a standard, 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, issuers of securities, originators of mortgages, and all manner of financial intermediaries and financial transaction processors.
ISO, SIFMA, and even the FSB had made public disclosures about what data should be included with the LEI code, i.e. name and address, parent company, domicile of official place of business, etc., but no public debate has yet been had on the actual content of the code standard itself. Of more significance, the International Standards Organization proposed a standard, approved by the majority of its member countries, under which the LEI would consist of 20 characters. The length was described, but nothing else. This is the standard now accepted by the FSB and the CFTC. There is dialogue expected on a further qualification for the construct of the standard within the LEI's 20-character code space as the FSB works on making a final recommendation in November to the G20. The devil, therefore, has been left to the details.
In the absence of such further definition, the DTCC/SWIFT proposal to the CFTC (the first agency set to use the LEI code) called for issuing a completely randomly generated number. The random number, as it turns out, is best suited to be assigned from a central point, not the multiple points of registration now contemplated in the approved G20 LEI implementation framework. SIFMA continues to advocate the centralized approach, in which the DTCC/SWIFT group would run the LEI utility. SIFMA, DTCC and others that had proposed to supply the CFTC with an interim identifier were expecting the Commission to decide on appointing an interim provider of a temporary LEI by the end of May, but it delayed the release of the new regulations, presumably to wait on the FSB's determination as to what will fill the code space.
Where does this leave the industry and the regulators? The industry and its regulators now need to pause and come together around the G20's table, leaving behind the earlier U.S.-centric, purely financial intermediary-led solution. This is too important – no single regulator should be "trading ahead" of the global standard and assume its own standard (an oxymoron) will become the global standard. That's putting the cart before the horse.
Allan D. Grody is the president and founder of Financial InterGroup Holdings Ltd.