When Lehman Brothers collapsed in 2008, market regulators, participants and administrators faced the challenge of having to quickly unwind the bank's trading and collateral positions. They needed to ask themselves, who owed what, and to whom, and exactly how much exposure did specific institutions have to the institution? Suddenly, exposures across market participants and asset classes were called into question, and market activity was disrupted.
This situation highlighted the need for a mechanism by which entity risk could be aggregated across multiple regulatory regimes and asset classes. A globally standardized legal entity identifier was viewed as a key building block in providing this transparency as it could help answer three questions: Who is the counterparty in a transaction? How does that counterparty look in terms of the broader organizational hierarchy? What do they own? Insight into these questions allows the industry to more effectively monitor and manage risk, and minimize threats to the industry.
Costly labyrinth of systems
There are several corporate identification systems operating in the Asia-Pacific region that address certain aspects of this challenge. Such local ID systems were designed for specific sectors or markets, be it to identify parties limited to certain jurisdictions, such as the broker-to-client assigned number for Hong Kong-mainland China trades and the Australian company ID for Australian firms, or to identify specific types of entities, such as dedicated IDs only for the financial industry. Adding to the complexity of managing multiple identifiers, some of these numbers may not be regularly updated for accuracy or do not provide the capability to attribute a parent or its subsidiary, which can lead to overlapping entities using the same ID in multiple financial transactions. At the core of the issue, these identifiers were not designed to be used as a global standard for identifying parties in cross-border financial transactions, therefore reinforcing the growing need for a globally recognised common ID system. In this scenario, the merits and efficiencies of adopting an industry-wide, globally recognised identification standard becomes clear.
We believe the established legal entity identifier (LEI) has several advantages which fulfil the need for a global standard identifier system. An LEI is a unique, 20-digit alphanumeric identification code that clearly, accurately and uniquely identifies all parties in a financial transaction. LEIs identify the direct and ultimate parent of a given legal entity, answering the questions "who owns what", "who is who" as well as now "who owns whom". LEIs are kept accurate and up-to-date by a global body that monitors its data and an online platform that lets any party challenge an LEI's accuracy.
Adopting LEIs as a global standard would also help businesses improve their "know-your-customer" (KYC) standards and enhance enterprise risk management. For example, banks could use LEIs to map an entity's ownership structure when assessing entity exposure. Businesses and regulators could derive value from being able to refer to a single database to source information on counterparties and security issuers.
Regulation boosts LEI adoption
Regulation has been a driver of LEI adoption, with some mandates specifically requiring the use of LEIs for compliance. The global LEI system is the only version recognised by trade reporting rules in the US and Europe, particularly under the Markets in Financial Instruments Directive Level 2 (MiFID II). Under MiFID II, the "no LEI, no trade" rule applies to all parties whose transactions involve a European institution at any stage of the trade lifecycle. This includes buy- or sell-side firms that operate wholly outside of the EU. As more firms use LEIs, it enhances the ability of regulators to obtain a more complete picture of risk across different jurisdictions.
Because of these mandates currently in place, the industry is well-positioned to adopt the LEI as the global standard – firms that want to remain competitive will have to obtain one to continue trading with an EU counterparty. Using the LEI as a standard will allow trading parties and regulators to simplify their data management process, as it will eliminate the need to manage multiple identifiers. As it stands, LEIs issued globally number close to 1.2 million, with more than two-thirds having been issued in North America and Europe. Asia accounts for roughly 4.1% of the total LEIs issued, and the region still has room to catch up with the rest of the world.
Consolidation reduces costs
Alternative identification solutions require their users to rely on a multitude of closed and costly ways to manage data, and ultimately provide fragmented information on legal entities in specific sectors. As a result, collating and standardizing information consumes resources. Consolidating around the LEI as the standard ID system across asset classes and jurisdictions would make it possible for banks, broker-dealers and other financial services firms to reduce risks and costs associated with their operations.
An analysis by the Global LEI Foundation (GLEIF) and McKinsey & Co determined that banks that adopt LEIs have the potential to derive savings of at least 10% of total operating costs for client onboarding and trade processing. For the broader investment banking industry, the same GLEIF and McKinsey report stated that industry-wide savings of at least US$150 million annually is possible while banks in trade financing could save an additional US$500 million per year by using LEIs when issuing letters of credit.
Identifying the parties involved in a financial transaction can be complex and costly. A single, unified database that tracks this information will help the industry reduce systemic risk, by increasing transparency, as well as cutting costs and reducing operational friction. This is what the LEI was designed to do.
Eugene Ing, executive director, DTCC GMEI utility