In the aftermath of the 2008 financial crisis, the leaders of the G20 nations took the first step to address the lack of transparency in the over the counter (OTC) derivatives markets. It was universally believed that if regulators and central bankers had timely access to more data on derivatives exposures, before and after the financial crash, potential risks could have been detected earlier and resolution would have been swifter. With this in mind, G20 leaders agreed that OTC derivatives transactions should be reported to trade repositories (TRs) to provide greater transparency into the health of the derivatives markets, leading to improved systemic risk mitigation.
Two things were clear about the derivatives markets at the time of the financial crisis, even without the data. First, the derivatives markets are interconnected and truly global, which means risk can spread from one jurisdiction to another through derivatives trading. In the lead up to the crisis, the risk of asset-backed securities structured in the U.S. found its way to portfolios around the world and was then either amplified or reduced using credit default swaps executed between counterparties across jurisdictions. Second, there are high concentrations of risk among a relatively small number of participants in the derivatives markets. That is not to say that these risks are inadequately managed, but rather the balance sheet strength and complex risk management responsibilities reside with a few, and therefore a clearing house or large global dealer often sits on one or both sides of most derivatives transactions.
Why are these two factors important in the context of the G20 commitment? Because any ecosystem designed to achieve the G20’s risk mitigation objective would need to allow for the collection of globally consistent data across jurisdictions, so that risk, exposures and interconnectedness could be understood irrespective of where the risk is booked. Also, while collecting data about every derivative trading counterparty may be useful, the most important part of monitoring systemic risk is collecting data on the clearing houses and dealers that are managing the majority of the risk.
Therefore, a simplified system that enables the global collection of a standard data set from a smaller set of systematically important players is more pragmatic versus a complex ecosystem that differs from one jurisdiction to the next, both in terms of the data required and the entities that need to report, which results in data that cannot be normalized, compared or consolidated.
By 2014, despite calls from the Financial Stability Board (FSB) and others as early as 2010 for global standards and coordination, it was clear that implementation of the G20 commitments was being driven by local regulatory requirements. The result was the creation of a complex local reporting network, falling short of the G20 expectations and expensive to develop and maintain for all reporting market participants and infrastructures.
A great deal of work has been undertaken since that time to advance the G20 vision. Under the FSB guidance, international standard setting bodies the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) have worked closely with market participants and regulators globally to propose guidelines for the use of Unique Product Identifiers (UPI), Unique Trade Identifiers (UTI) and other OTC Critical Data Elements (CDE) for trading reporting. CPMI-IOSCO also recommended governance functions to cover maintenance, oversight and implementation of CDE.
For CDE there were 110 proposed data elements that regulators agreed should be standard and could be used in each jurisdiction to address the issue of jurisdictional differences. CPMI-IOSCO also suggested that CDE should be defined and maintained in the ISO 20022 data dictionary arguing that it will facilitate their inclusion into standardized messages and help participants program CDE into electronic messaging systems thus encouraging a systemic approach to CDE implementation.
Everything seemed to be in line at long last, with clearly defined data standards, a formatted message to capture the data elements and a governance process to oversee the implementation. Each regulator could implement CDE and still ask for additional data elements as an extension to the standards if they felt that the 110 data elements in the proposed guidelines were insufficient for their needs. However, as we write this, there are warning signals that these harmonization efforts could fall short, resulting in all industry players upgrading their systems to be compliant with the new requirements only to continue to face an inconsistent approach to global reporting.
The two largest derivatives regulators, the European Securities and Markets Authority (ESMA) and the Commodity Futures Trading Commission (CFTC) are currently in various stages of implementing rule changes to adopt CDE. The CFTC has issued its final re-write rules and ESMA is in the consultation stage with the industry. Having governance and standard definitions in place before the rule rewrites began would have been a more logical sequence. The Legal Entity Identifier (LEI) Regulatory Oversight Committee (ROC) was only recently appointed as the governance body for the implementation of UPI, UTI and CDE and the ISO 20022 message for CDE has not yet been defined.
Furthermore, an analysis of the ESMA refit proposals and CFTC rewrite has uncovered that the CFTC will be adopting only 78 of the 110 CDE and ESMA only 87. Of the proposed CDE, only 53 elements are being adopted by both CFTC and ESMA and will be reported in a standardized format across both jurisdictions. While this will have moved the needle in the direction of consistent global reporting, the result will be a continuation of the same—a significant number of non-standardized data elements falling short of the FSB’s desired objective of enabling global data aggregation. If other regulators follow this early pattern, it will result in much change and cost for very little reward. Certainly, regulators may need data beyond the universally agreed upon elements. However, adoption of data elements with even slight differences from the CDE will frustrate the goal of a global standard set of data.
With TRs and market participants about to start to revise their systems to adapt to the new rules, now is the time to get this right. It is not too late to review CDE again to create a standard representation of key data elements that all regulators can universally adopt as they rewrite their rules. It is not too late to define a standard message format using ISO 20022, or any other standard, to be implemented in the new local rules. And it is not too late to ensure that the LEI ROC has the resources and processes in place to oversee the regulatory implementation. Otherwise we will be no closer to delivering upon the G20 commitment to create greater transparency in the OTC derivatives market in order to mitigate systemic risk in global financial markets.
This article was originally published in Global Risk Regulator.