By Alan Grody, president, Financial InterGroup Holdings
The CFTC recently requested comments on improvements to its swaps risk regime. In its request it recognised the importance of appropriate regulation to create and use data to fulfill the overall framework objective of systemic risk analysis. To date the swaps data reporting and record keeping initiative is overflowing with incomprehensible data, what in an earlier era would be termed GIGO, garbage in garbage out.
The automation of data reporting and record keeping has evolved along with the development of risk management, data management, and information and communication technologies. Data is created and enabled through information technology applied to business process and practices, and to regulations overseeing both. After the 2007-2008 financial crisis industry best practices have been questioned and government oversight has changed as a consequence. Fundamental data weaknesses have been discovered. Prominent among such discovery has been the absence of a global identification system for identifying parties and products in the financial supply chain. A fundamental pillar of all global technology advances in our global economy was absent in global financial markets.
To date a first step has been taken to fill this gap. A global government standards body, the Financial Stability Board, has been empowered to set industry and regulators on a path toward global standards for identification and aggregation of financial transaction data. A rudimentary interim global legal entity identification system (GLEIS) in the US has been operating for nearly two years under a CFTC temporary order and elsewhere under sovereign regulator sponsorship of facilities operators, referred to as local operating units (LOUs). At this time neither the technical core of the required federated internet-like GLEIS nor the central operating unit’s virtually aggregated data base of all separate LEI registries has been designed.
Further, the remaining parts of the overall global identification system (GIDS) for financial product and transaction identification, for metadata describing the LEI and these other identifiers, and for data tags describing transaction data details, remains to be done. Also, the current interim GLEIS has no provisions for maintaining the LEIs that undergo corporate reorganizations, no mechanism to aggregate data through to its control entity and/or parent entity organizational structure, and no linkages between products and entities issuing/trading those products.
In the rush to declare safe passage from the financial crisis, financial markets participants have been forced by hasty regulations to send data to newly mandated swaps data repositories (SDRs). This is the first use of the global identifiers even though partial implementations, incomplete understandings of business practice, and poorly designed solutions are apparent. Later implementations call for the global identification of all financial market participants in all contracts and instruments.
In the spirit of this being, at its root, the implementation of a global technology solution for implementing a global capability to assess systemic risk across all parties and all trades it is best to refer to this first use as a ‘beta’ version, not yet industrial strength. It awaits redefinition and a revised next version for use in reporting and recording swaps transactions.
In its defence, the CFTC had been given a herculean job but with too little resources. It is to carry out its regulatory mandates while global forces are at work, in rapid technology advances and in financial market innovation. Financial institutions and markets are global and know no sovereign boundaries. At the same time financial markets are globally integrated from a functional point of view but not from a regulatory or technical perspective. A lot still needs to be done to align regulation with its primary implementation resource, automated business process. Data standardisation and its use for data aggregation are paramount in automated record keeping and reporting.
Further, missing to this point was the global identifiers for the instruments and contracts traded in (Unique Product Identifier -UPI), and an audit trail tying transactions together throughout their life-cycle (the Unique Transaction Identifier -UTI). No amount of automation would be effective for either risk management or trading on a global scale without such a global identification scheme.
Toward this end, after the financial crisis of 2007-2008 the heads of state of the G20 countries gave a mandate to its new creation, the Financial Stability Board to “stabilise the global economy” by promulgating standards and coordinating regulations globally. To their credit one of the first initiatives the FSB accepted nearly four years ago was the global legal entity identification (LEI) project.
Another initiative, equally important, and accepted by the FSB was to create a consistent mechanism for implementing derivatives reform with a specific early emphasis on swaps regulation. The first use of the new data standard and data aggregation regime is being tested simultaneously with the new swaps data reporting and record keeping regime.
With universally accepted identifiers embodied in financial transactions it was expected that regulators could recognize and aggregate identical counterparties and swaps transactions and components of those transactions into valued positions and cash flows. It was expected that this could be done by computer means across business units of individual firms, across multiple financial institutions, and across financial market infrastructure utilities.
More directly related to swaps data record keeping and reporting, it was expected to enable data aggregation across counterparties and their controlling business entities as those transactions were reported to swaps data repositories (SDRs). Unfortunately this has not occurred even though data is being reported to SDRs under regulations by the CFTC and by other regulators in other sovereign jurisdictions.
To begin this journey, in 2010 the CFTC, the SEC and the US Treasury asked for a set of unique codes, being the counterparty identifier code, the UPI and the unique swaps identifier, now called the UTI. These three agencies had requested a single integrated solution to all three identifiers.
The momentum for implementing this bar-code-equivalent for financial services now comes from the G20, passed on from the US Treasury’s office of financial research to the G20’s Financial Stability Board (FSB) and now to the Regulatory Oversight Committee (ROC). It will soon be passed to a board of directors that will make final decisions and implement a core facility, the Central Operating Unit, yet to be defined in any detail.
Only recently has the ROC made it a requirement to have the legal entity self-register itself. The earlier approach allowed third party facilities operators to both register and code the legal entity. Now only the code, referred to as the pre-LEI is to be created and assigned by domestically approved facilities operators. So far DTCC/SWIFT is the CFTC’s chosen operator in the US, WM DatenServe and the German Federal Register is Bafin’s in Germany, INSEE in France, the Irish Stock Exchange appointed by its Central Bank for Ireland, the LSE’s Sedol subsidiary is the chosen facility operator in England, Takasbank in Turkey, the Dutch Chamber of Commerce in the Netherlands. To date 25 operators have been identified to date, with half actually operating to issue pre-LEIs.
Pre-LEIs are being implemented in an interim system in what was thought necessary for immediate use in regulating the swaps markets. Its first use was to aggregate swaps data in multiple swaps data repositories (SDRs) in the US and across the globe. However, multiple counterparty identifier codes have been allowed rendering the data associated not useable for aggregating risk exposures by counterparty.
It is expected that these pre-LEIs can, over time, be transitioned to the global LEI system for use in risk data aggregation for all financial transactions engaged in by all financial market participants globally. Such aggregation of data will be required for systemic risk analysis across multi-located business silos of individual financial institutions, with financial supervisors set for testing such functionality beginning in 2016. It will also be required to aggregate data across geographically dispersed global financial institutions domiciled in multiple sovereign jurisdictions. This later capability has yet to be defined.
Data aggregation will require data linkages between legal entities of the same controlling business entity. This will further require relationships and hierarchies of ownership to be organized within the GLEIS or outside of it. Notwithstanding that it was the presence of multiple non-unique identities, the absence of linkages between them and the inability of regulators to observe these linkages that caused risks to cascade across the globe. This was observed by regulators as the ‘Lehman problem’ with its 3300 legal entities, later to be understood as an industry problem that gave impetus to the GLEIS initiative. This data linkage mechanism has yet to be defined as well.
The absence of a requirement of a control entity/parent entity at the initiation of the swaps data reporting regime is one of the inhibitors preventing swaps data from being aggregated for risk analysis by the CFTC and by other regulators. To this immediate need we have been advocating for affixing such an identifier to the pre-LEI, the preliminary LEI now being used for swaps reporting.
We think the building blocks of the foundation of the GLEIS and the overall global identification scheme have been set down before the full purpose has been understood and the system and identification code design fully considered. The consequences are apparent, data and an identification scheme that is not fit for purpose, both to the FSB who has requested comments to its consultative paper on OTC Derivatives Data Aggregation in Trade Repositories and by the request for comment by the CFTC.
A more complete version of this article, in the form of Financial InterGroup’s response to the CFTC’s
Request for Comment on Swaps Data Reporting and Record keeping posted on May 27, 2014 can be found at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=59876&SearchText=.