One of the lessons learnt from the global financial crisis (GFC) in 2007-2008 was that early threat detection is essential to risk mitigation and crisis prevention. It became evident to regulators that effective detection was hindered by the fact that financial institutions around the world did not have a single, common identity attached to any financial transactions, making it challenging to identify counterparties and hence calculate risk exposure.
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What Happened Next?
The Legal Entity Identifier (LEI) system was among the various financial reforms launched in response to the GFC to promote stability and build flexibility within the financial markets. Launched in 2011 as a unifying regulatory reporting data element, with the added benefit of helping firms enhance their internal risk management system through the collection, standardisation, and aggregation of reported data, the LEI is a specific, 20-digit alphanumeric identification code that was set up to uniquely and accurately recognise entities involved in a financial transaction.
Applying for LEIs is an easy process. As part of the LEI system, established Local operating units (LOUs) are tasked with issuing and maintaining LEIs while the Global Legal Entity Identifier Foundation (GLEIF) provides oversight on the quality, integrity, and value of LEI data. As LEI registration is straightforward, adopting LEI as the global standard identifier to mitigate risk at all levels – firm, country, industry and global – is being considered.
The LEI was created to be the global standard identifier for regulatory reporting but its founding principles had always envisioned is use beyond this use case. Aside from risk management, an LEI can minimise the number of touchpoints across the trade lifecycle to expedite the completion of a trade. By utilising an LEI as reference data, it can help firms supplement their “Know Your Customer” process to facilitate client onboarding, providing firms with a quick and comprehensive snapshot of existing and new clients.
With LEI data introduced earlier in the trade lifecycle, firms can also efficiently match and confirm trade details between counterparties to increase operational efficiency and reduce time spent on data reconciliation. And when an LEI is linked to a central database of standing settlement instructions (SSIs), firms can streamline post-trade processing by pairing transactions with counterparties to advance to settlement.
The merit of linking an LEI to SSIs is further emphasised in a report dated April 2022, “Charting the Future of Post-Trade”, that was developed by members of the task force initiated by the Bank of England (BOE) and the Financial Conduct Authority (FCA). The report highlighted that while an LEI is regularly used in derivatives trading, in the case of cash transactions, LEIs are used too little and too late while SSIs are too often exchanged manually, leading to high costs and trade fails.
The recommendation offered in the report was to create a new post-trade industry leadership group comprised of willing participants from across the industry to work together to develop and promote a set of best practices on sharing LEIs early in trade-lifecycles and to create efficient, electronic processes for communicating SSIs.
Here in Asia, LEIs are increasingly being used in markets like Malaysia for payment transactions to streamline the online payment process as well as enable fast and accurate identity management.
Will Increasing Regulatory Requirements Drive Further Adoption?
According to GLEIF, the governing body of the LEI system, there are now more than 2 million active LEIs issued globally, with Asia making up approximately 11% of the total active count. The question remains whether ongoing changes in regulatory requirements could continue to expand application of the LEI.
So far, European authorities, in keeping with the original thematic review following the GFC, have implemented regulatory mandates. The often-mentioned “no LEI, no trade” is an extraterritorial prerequisite of the Markets in Financial Instruments Directive II (MiFID II) that necessitates the inclusion of LEI data to recognise any counterparty – in Europe or elsewhere – involved in domestic and cross-border trades.
The European Markets Infrastructure Regulation (EMIR), the Securities Financing Transaction Regulation (SFTR), the Alternative Investment Fund Managers Directive (AIFMD), and Solvency II are some of the other European regulations that also stipulate LEI requirements in trade and transaction reporting.
In the US, the LEI has both been mandated and endorsed for the reporting of over-the-counter (OTC) derivatives contracts to financial regulatory authorities. In Hong Kong, an LEI is required for derivatives reporting as stipulated by the Hong Kong Monetary Authority (HKMA).
With the various regulators in Australia, Japan, Singapore, Europe, and the US working on rewriting their specific rules to drive global data harmonization in OTC derivatives trade reporting, the CPMI-IOSCO working group on harmonisation has proposed that LEI data along with Unique Transaction Identifiers (UTI) and Unique Product Identifiers (UPI) be adopted in the regulatory rewrites to facilitate global aggregation and analysis of reported trade data.
The combined data – based on common data standards – would enable trade repositories to collect and maintain quality data needed to monitor, manage, and mitigate systemic risk.
What is the Vision Ahead?
As LEI information becomes more prevalent within financial firms, the industry gradually moves closer to the financial reform agenda of attaining a more thorough view of risk review and assessment across asset classes and multiple jurisdictions.
For firms that are not impacted by extra-territorial regulatory mandates, using LEI as the global data standard eliminates the need for multiple identifiers or unifies other reference data used to identify counterparties. Doing so will bring about a more streamlined operational approach and reduce the risk of linking the wrong entity to a financial transaction.
As the “Charting the Future of Post-Trade” report put forth: solutions need to be more standardised and more interoperable, and leveraging a single, centralised repository to track parties in a financial transaction will enable greater transparency, cut costs, and reduce operational risk for the industry.
This article was originally published in Regulation Asia on October 28, 2022.