Mark Davies, General Manager, Avox
With new rules relating to risk management and investor transparency entering into force in recent years, the ability to precisely define, source and manage legal entity data is reaching the top of the agenda for market participants. The legal entity identifier (LEI) is just one of a number of legal entity data attributes that is fast becoming one of the most important tools for regulators monitoring the build-up of systemic risk.
The idea of an LEI, first mooted in 2010 by the U.S. Treasury’s Office of Financial Research, was subsequently written into law under the U.S. Dodd-Frank Act and applied to the reporting of over-the-counter (OTC) derivatives trades by banks and brokers which began in 2012 so that regulators had a clearer view of market participants’ swap positions and exposures.
Regulation of the European derivatives market followed shortly after in February 2014 when sell-side and buy-side firms had to begin reporting their OTC and exchange traded derivatives to ESMA-authorized trade repositories, such as The Depository Trust & Clearing Corporation’s (DTCC) Derivatives Repository Limited, known as the Global Trade Repository (GTR).
More than one year since the use of LEIs for reporting derivatives trades in Europe began, regulators are now turning their attention to other asset classes and market participants operating in financial markets. As part of the transaction reporting requirements under the Markets in Financial Instruments Directive (MiFID) II, market participants that purchase and trade securities will be required to source and map LEIs for the issuer of each security instrument. Worryingly, however, a significant number of corporates who issue securities in order to raise capital are unaware of their legal obligation to obtain an LEI under the Directive.
As a result, many market participants are making efforts to educate the corporate clients that they have direct relationships with about the need to obtain an LEI. However, this becomes more complex when fixed income instruments are sold in the secondary market because, unlike equities, bonds are issued and traded OTC, so there is no direct relationship with the organization that issued it and a third party is introduced.
What’s more, of the 64 mentions of LEIs in the most recent MiFID II consultation, a number refer to the requirement to identify the ultimate parent of the issuer of a security. The ability to maintain high quality information regarding companies and their ownership structures will not only help firms to view their total exposure to an entity, it would greatly simplify the task of reacting to credit crises and potential losses should an issuer default on any payment obligation. Furthermore, it will provide national competent authorities (NCAs) with the ability to analyse risk on an aggregate firm level.
The financial markets are replete with investment analysts and investors who dedicate their efforts to familiarise themselves with every detail of a particular stock or bond and the variables that are likely to affect its performance in the future. It seems, however, that a lesser number are familiar with the detailed corporate structure and hierarchy of an issuing entity and other entity data attributes that can provide key insights into the risks of providing finance to a particular company. And the same can be said of the lenders and investors themselves; if a company wants to raise capital, they must be fully furnished with accurate legal entity data associated with the investment firm or bank that is providing the financing. For corporate treasurers, this presents the potential to more accurately project future cashflow, as well as conduct due diligence on where market funding is originating from.
MiFID II, set to enter into force in just over 18 months, will capture a much greater number of firms operating in financial markets, not only those providing funding but those in search of it. A recent survey carried out by Avox’s parent company, the DTCC and Aite Group, found that 50 percent of firms viewed MiFID II as one of the most important regulations to affect their data management processes and functions over the next 12 months.
While all of these firms will be affected by the Directive and its accompanying requirements to a lesser or greater extent, their ability to have a clear view of risk associated with each of their counterparty relationships will be an essential component of best practice risk management, and one that will ultimately underpin regulatory efforts to monitor the build-up of risk in the financial system.