A research note by Financial InterGroup
Global interest in the concept of the unique transaction identifier – UTI; unique product identifier – UPI; and the legal entity identifier – LEI, has met with universal acceptance. For financial institutions these ‘Barcodes of Finance’[i] are expected to allow for straight-though-processing as the barcodes of commerce have done for the commercial and retail trade supply chain. For regulators it is expected to provide an automated means to observe the buildup of enterprise risk across silos of businesses within each financial institution and systemic risk across the global financial system.
The derivatives industry has been singled out as the testing ground for the launch of these codes. Eventually all reporting entities in all markets by any financial market participant will have to get a LEI and use UTIs and UPIs in their submissions to regulators. Banks today are being asked to submit LEIs on Federal Reserve reporting forms.[ii] Mutual funds, money market funds and other collective funds have to be report with LEIs to the SEC. Regulators want these codes so they can aggregate data for systemic risk analysis. Global regulators’ recent consultation papers lay bare the difficult road ahead.
In 2012 a version of the LEI code was distributed in the US under CFTC’s new swaps regulation. LEIs were later changed to conform to a global version under Financial Stability Board standards. In 2014 the EU began distributing LEI codes under the new FSB format. Multiple versions of the UTI and UPI codes were created and, along with the LEI, included in swaps transaction data sent to trade repositories (in the US referred to as swaps data repositories – SDRs).
Now, three recent public consultations, all initiatives sponsored by the G-20’s Financial Stability Board (FSB), are laying bare the issues confronting these codes in their inaugural implementations. The three papers, one issued by the International Organization of Securities Commission (IOSCO) and its Committee on Payments and Markets Infrastructure (CPMI) Board, the other two by the FSB’s appointed Regulatory Oversight Committee (ROC), has recently or will shortly close out their comment periods – Sept. 28th for IOSCO/CPMI; Oct. 19th and Nov. 16th for the ROC.
The IOSCO/ CPMI consultation paper [iii] proposes to use the LEI as an element (a prefix or name space) for constructing the unique transaction identifier (UTI). ISDA members are already using a shortened version of the LEI for such purposes. However, unresolved issues surrounding the LEI as well as the UTI and UPI have surfaced.
The LEI issues are surfacing through industry comment letters posted to earlier public consultations of various regulators. Among the issues identified is those by the Investment Company Institute. They describe the problems that collective funds (mutual funds) have in accessing the correct legal entity where intermediaries are involved, such as those issuing LEIs (local operating units – LOUs) and third parties such as collateral agents. Immediate access is necessary when identifying legal entities to report counterparty or collateral providers for swaps transaction reporting.[iv]
Another issue is addressed in the IOSCO/CPMI paper itself regarding the maintenance of the LEI. While corporate or life cycle events can change the controlling parent of the LEI an early assumption was that the LEI code itself would be unchangeable, only the corresponding reference data in the LEI Registry would need changing. In practice this is not possible when such corporate events take place.
In the GLEIS a change in control of a legal entity (as a counterparty in a trade, or a reference entity in a credit default swap, or as an issuer of underlying securities) may require that the assigned LEIs be flagged as “expired” and a new LEI assigned. Each LEI registry maintaining that code, as well as trade repositories maintaining transactions containing those LEIs, would have to be updated. In a later phase of the GLEIS, each instance of its appearance in the hierarchies of the old and new LEI would also have to be updated.
The front end mechanism to resolve this problem is being addressed, although outside the GLEIS. XBRL International, the organization overseeing the data tagging language for financial reporting has been attempting to get issuer entities to be involved in reporting these corporate events at the source of the creation of such notices. This is the same at-source point as when a legal entity is required to register or change its LEI identity.[v] This maintenance function of LEIs has yet to be coordinated in the interim global LEI system (GLEIS) where thirty (30) LEI Registries exist globally nor in the twenty-five (25) instances of globally disbursed trade repositories which can be expected to encounter similar issues.
The CFTC itself, recognizing their inability to aggregate swaps data being reported to multiple trade repositories, in the US alone there are four, requested a formal review of some of these issues in their 2014 consultative paper “Review of Swaps Data Reporting and Recordkeeping Requirements”.[vi] The swaps data reporting regime is dependent on the global identification system of the LEI, UPI, and UTI to provide for data aggregation. Many of the questions posed in the review were related to improvements to these identifiers as well as the data tagging language used to describe other data elements for inclusion in swaps transaction reporting.
In the summer of 2015 the CFTC responded to the many comment letters received, although responding primarily to cross border issues of reporting obligations of cleared swaps. They did not respond to the remaining issues of data standards but it was noted that they remain to be resolved.[vii]
Further, in a most recent publication, ESMA has released its final rule on MiFId II and MiFIR[viii]. In it the ROC acquiesces to allow sole proprietors to be issued a LEI.[ix] Also ESMA has accepted that transactions needn’t be checked to see if LEIs have lapsed. On this later point ESMA seems to have relied on a misguided understanding that LEIs lapse because the maintenance fee is not paid, a symptom not the cause of the LEI lapsing. Not surprising, EU regulators are contemplating postponement of the implementation date of this regulation to allow technology issues to be resolved.
Finally, ISDA, SIFMA and a number of other trade associations, referred to as the ‘Joint Association’, recently commented on the poor quality of data being reported to trade repositories. They suggested a need to expand on the existing identification system and harmonize data reporting requirements across regulatory regimes. [x]
The other two recent consultation papers, issued by the ROC, proposes, in the first paper to collect data on direct and ultimate parents of legal entities in the GLEIS [xi] and in the second proposes to assign LEI codes to international branches of financial institutions [xii]. The former is expected to permit the consolidation of financial transactions containing LEIs and the latter is an expansion of permitted financial market participants that can obtain a LEI.
The definitions of ultimate parent in the ROC consultation is based upon public company audited financial statement consolidation principles. It is hoped that following these accounting principles will allow for transactions that are first aggregated across multiple globally disbursed trade repositories to be aggregated up the counterparty chain to its ultimate parent for risk purposes.
It was obvious from the launch of the LEI code in the US in July 2012 that LEIs were being issued before global standards were set. The result is that non-conforming and duplicate LEI codes and legal entities exist, as well as non-certified and lapsed LEIs. It was also known, even after the FSB standardized the code construction, that there would be no means to aggregate transactions up to its parent entity using these randomly created twenty character codes. That would be addressed in a second phase, now being addressed by the ROC’s consultation paper.
The absence of codes for branches, the subject of the ROC’s second consultation, and as with the recognition of sole-proprietors, is an admission by the ROC that it failed to account for these categories of financial market participants in the initial conceptualization of the GLEIS. This too should not be surprising as regulatory frameworks, of necessity, lack detail. However, it can prove catastrophic when a system has already been launched and is in use as is the case with the GLEIS.
The UTI was also launched, both in the US and elsewhere, without a standard coding convention. The UPI, like the UTI, is also in use without consistent ways of constructing it. In its UTI consultation paper IOSCO/ CPMI notes the UPI will be addressed in a subsequent public consultation planned for later in 2015. To add further confusion to the UPI issue ESMA’s most recent final rules on MiFID II and MiFIR unilaterally embraces the ISIN code for product identifiers, noting that ISIN still has to assign codes to cover derivatives. It is obvious that all three barcodes of finance (the LEI, UTI and UPI) needs to adhere to a global standard in order for it to be fit for all its intended uses.
The three codes were to be the pillars supporting a paradigm shift in global financial transaction transparency. Its first implementations are taking place in the swaps markets where billions of transactions are being reported with these codes. It has not gone well. In addition to non-standard identifiers, the problems are compounded in that there are no useful global standards identifying counterparties’ controlling entities and no common definitions of data elements comprising a swaps transaction. This has left regulators with no computerized means of accessing or aggregating transactions for risk analysis, this being the first objective for their use.
The LEI is assigned and its business card data (name & address) recorded by LOUs. LOUs (local operating units) are facilities operators given the franchise by regulators to operate an LEI registry in a sovereign jurisdiction. LOUs currently include data vendors, financial market utilities, government patent offices, national business registries, stock exchanges, central banks, software companies and national economic institutes. They are all attempting to validate data from its originating source, the registrants’ own input, but using multiple secondary sources of electronic and manually produced public and private data, thus adding layers of errors of human interpretation and omission.
Critically, while the LEI is now exclusively being assigned by regulation to swaps market participants, this is only one tenth of the potential issuance expected in support of all financial participants in all markets, the end objective for LEI issuance. In addition, the LEI lacks real-time updating and maintenance in an era where financial transactions are increasingly processed in real-time. The LEI is in need of evaluation of fitness of purpose as it is now being proposed to be used universally as the a linchpin for the construction of the UTI and possibly the UPI even while falling short on its earliest objectives for uniqueness, high standards of data quality, timeliness and use in data aggregation for risk assessment
In their consultation paper the ROC references consolidated financial statements as a key source to validate parent relationships based on accounting definitions within the scope of public audits. These statements are usually certified by external auditors.
It would seem a natural extension of the auditors work to organize this data in computer readable form, co-jointly certify the validity of the data with its client, place it in a standardized template using XBRL tagging conventions (commonly used by auditors in financial statement reporting) and register it in the GLEIS directly. This would eliminate the necessity of validation through secondary sources, a costly and burdensome effort now performed by LOUs for individual LEIs.
Timing of updates is especially important in the case when corporate reorganization such as mergers, acquisitions and spin-offs need to be timed precisely to be effective across all LEIs of a single parent entity wherever their component LEIs are registered or recorded. Many companies are required by regulation to register their component legal entities in LOUs in their country of domicile.
The maintenance of LEIs due to ownership changes still needs to be developed in the GLEIS, and in trade repositories. This problem was identified in the ROC’s current public consultation paper when referring to changes of ownership and control of LEIs. They suggest using accounting consolidation standards within auditor prescribed timetables but they note that consolidated financial statements are not updated in real time, only at quarterly or annual intervals. While this conveys their interest in more frequent updating, if not real-time updating, it is not explicitly stated.
To this end it should be reasonable to conclude that timely availability and processing would be desirable if suitable, practicable solutions were presented. For example, auditors’ third party assurance services can be used to certify LEIs; to provide updated XBRL templates for registering and updating changes to LEIs; and to record, update and register hierarchies of ownership following account consolidation principles.[xiii] Auditors are privately informed well in advance of the public when legal entities come into existence and changes are to take place.
Also when the FSB agreed to direct the creation of the GLEIS they accepted the proposal to use the Internet’s underlying technology to aggregate data across the multiple LEI Registers. That was the recommended architecture accepted by the FSB but which has not yet been included in the GLEIS’s design. This technology should also be included as a requirement to aggregate data across trade repositories.
Further, the earlier proposal by IOSCO and others for automating data aggregation by using the controlling consolidating parent LEI as a prefix for all legal entities should be revisited.[xiv] An at-source method for generating global UTIs using the LEI as a prefix is just now being considered in the IOSCO/CPMI consultation paper. Its further use for designing the UPI would ease the burden of associating legal entities as manufacturers, obligors, or guarantors of contracts or issuers of investments. The LEIs twenty (20) character length has also proven troublesome in fitting in with data fields in legacy systems. It could be halved and still be universally assignable and long lived.
These at source approaches and use of a shortened LEI and unique company related LEI prefix had been proposed before by regulators and industry but dismissed, principally by market infrastructure intermediaries and data vendors who have kept code assignment for themselves. Financial market participants may find it easier to embrace self-assignment of codes, using their own codes, as is done today in global commerce and on the Internet while preserving global uniqueness.
Many market infrastructure intermediaries dominate the industry with data warehouses of an earlier era supporting high fixed costs and risky reconciliation and mapping processes. Fortunately, we are in unprecedented times. Capabilities exist today to aggregate and distribute billions of transactions in real time across globally disbursed data bases. The Internet and the World Wide Web are examples of such fundamental capabilities.
With unique, universal and unambiguous identifiers and common data elements housed in data bases across the Internet and accessible through Internet protocols, much of the industry’s legacy architecture can be redesigned for real-time processing at lower cost and less risk. The financial industry already has vast Internet-based virtual private networks threaded throughout the financial services industry. Search and aggregation techniques designed for the Internet can be deployed in finance, giving instantaneous access to disbursed data. This is the technology and techniques that give us instant access to the World Wide Web’s data via a simple search query.
Certainly the technology of today, high speed Internet based communications networks deployed in so many industries outside of finance, and pursued aggressively for revenue generation at the front end of our industry, should be pursued as well in the middle and back offices of financial firms.
Deploying these new technologies in operational areas (the focus of the Barcodes of Finance) had always been disadvantaged by the underfunding of cost centers, favoring instead the funding of revenue producing areas. This forced legacy systems to be extended beyond their reasonable life, and created a legacy mindset that accepted minimum funding for new technologies. This, even though the benefits to the industry of embarking on this identification journey was to be found in pursuing straight-through-processing.
It is not too late to revisit the base line assumptions that gave us this false start that now encumbers the industry and regulators with non-standard and non-aggregatable codes placed in billions of transactions sitting in swaps data repositories. Regulators’ public consultations noted above need to be responded to within a more forward looking vision, not in ways that perpetuate more incremental legacy “make-dos” that impose more technology, operations and regulatory burdens.
The consequences of missing data elements and functionality from its inception in the design of such an ambitious global identification system is being accommodated by attempts at incremental additions. In systems terms it is referred to as “patches”. A new system already being “patched” while still only accommodating participants, products and transactions in just one market, swaps, where problems have already arisen, does not bode well for its success when the promise of the system is to eventually accommodate all financial market participants in all markets.
A fundamental rethink is in order now that the system is providing a live but dysfunctional case study. If not the financial industry is destined to continue perpetuating the Rube Goldberg or Heath Robinson infrastructure it is burdened with now, those ridiculously complicated machine depictions designed to accomplish a simple objective but with great complications.
References
[i] Grody, A.D., Hughes, P.J. Risk, Data and the Barcodes of Finance, Sept. 28, 2015, http://ssrn.com/abstract=2544356
[ii]American Bankers Association, Expanded Reporting of Legal Entity Identifiers, May 19, 2015 http://www.aba.com/Advocacy/commentletters/Documents/LEIReportingLettertoFRB.pdf
[iii] Committee on Payments and Market Infrastructures Board of the International Organization of Securities Commissions. Consultative report – Harmonisation of the Unique Transaction Identifier, August, 2015
https://www.bis.org/cpmi/publ/d131.pdf
[iv] Investment Company Institute, Response to the proposed Investment Company Reporting Modernization and Amendments to Form ADV and Investment Adviser Act Rules, August 11, 2015 www.ici.org/pdf/15_ici_sec_reporting_modernization_ltr.pdf at page 55- 56
[v] XBRL International, XBRL International Calls for Global Working Group to Define Standards for Corporate Actions Reporting, May 28, 2014, https://xbrl.us/news/xbrl-international-calls-for-global-working-group-to-define-standards-for-corporate-actions-reporting/
[vi] CFTC Review of Swap Data Recordkeeping and Reporting Requirements, March 26, 2014, http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2014-06426a.pdf
[vii] CFTC, Statement of Commissioner Christopher J Giancarlo, Aug. 19, 2015, Notice of Proposed Rulemaking on Amendments to Swap Data Recordkeeping and Reporting Requirements for Cleared Swaps
[viii] ESMA, Final Report Draft Regulatory and Implementing Technical Standards MiFID II/MiFIR Sept. 28, 2015, https://www.esma.europa.eu/system/files/2015-esma-1464_-_final_report_-_draft_rts_and_its_on_mifid_ii_and_mifir.pdf
[ix] ROC, statement clarifying the conditions under which individuals acting in a business capacity are eligible to obtain LEIs, Sept 30, 2015.
[x] Joint Association letter on global trade reporting and data harmonization “Key Principles to Improve Global Trade Reporting and Data Harmonization”, June 11, 2015, http://www2.isda.org/attachment/NzY1OA==/Joint%20Trade%20Association%20Data%20Harmonization%20letter.pdf,
[xi] LEI ROC, Consultation document on collecting data on direct and ultimate parents of legal entities in the Global LEI System, Sept. 7, 2015, http://www.leiroc.org/publications/gls/lou_20150907-1.pdf
[xii] LEI ROC, Consultation document on including data on branches in the Global LEI System, Oct. 19, 2015, http://www.leiroc.org/publications/gls/lou_20151019-1.pdf
[xiii] Grody, A.D. Hughes, P. J., The Global Risk Regime – New Roles for Auditors, Sept. 28, 2015,
http://ssrn.com/abstract=2508399
[xiv] CPSS & IOSCO, Report on OTC derivatives data reporting and aggregation requirements Final Report, Annex 3, Jan. 2012, http://www.bis.org/cpmi/publ/d100.pdf at footnote 111 page 65