It is a widely held belief that large positions in OTC derivatives held by some financial firms — most notably AIG — exacerbated the 2008 financial crisis, due in large part to poor risk management and a lack of adequate margining. Taken unaware by the systemic problems brewing in their midst, regulators have spent the last four years working to correct the situation.
In June, the G20 endorsed recommendations by the Financial Stability Board (FSB) for the creation of a global Legal Entity Identifier (LEI) system that would uniquely identify parties and link them to financial transactions. Beginning with OTC derivatives transactions, the system is intended to enable regulators to aggregate positions by LEI to monitor and mitigate systemic risks in global markets. Investors and private parties, too, hope the system will help them by providing useful information about market risk. When completed, it is expected that the global LEI system will apply to other kinds of transactions, possibly fixed-income and equity securities.
Creators of the LEI system have said they hope to define eligibility for firms seeking LEIs as broadly as possible. Application criteria are expected to be comprehensive enough to encompass markets and products as they evolve over time.
Even though the FSB is seeking broad adoption by local regulatory regimes, it has no means by which to require or enforce adoption. Accomplishing adoption and, ultimately, enforcement will require high-level political agreement from local jurisdictions as well as from the industry.
None of this will be easy. There are ongoing debates about privacy laws, sovereignty, and who will ultimately maintain control over the data. Despite these difficulties, most understand the potential of the LEI system in mitigating risks within the global financial system. Consequently, the FSB is trying to create a workable solution by tapping experts and regulators from all over the world. The FSB has proposed a governance framework, an operational model, and a funding model while the Global Financial Markets Association (GFMA), a private industry group, in conjunction with 68 major global firms and trade associations, has recommended organizations it believes are best suited to operate a global LEI system. Whether or not the FSB will take GFMA’s recommendations remains to be seen.
In the meantime, a number of jurisdictions are establishing interim identifier systems. The U.S. Commodity Futures Trading Association (CFTC), for instance, has named DTCC-SWIFT as the interim compliance identifier system that will be synchronized with the global LEI system once it is ready. Likewise, the European Securities and Markets Authority (ESMA) has proposed creating an interim entity identifier system.
The Herculean goal is to establish a global LEI system in accordance with the FSB recommendations by the end of 2012, with the system independently functional by March 2013. At this point, it remains unclear — even among derivatives experts — whether they can achieve and implement that goal, and especially whether it can be done well in the desired time frame. Stay tuned.