Rather than the idea of a ‘dummy’ legal entity identifier, as seems to be popular within the practitioner community Andrew Liegel, deputy vice president of regulatory and risk solution vendor FRSGlobal’s US operations, reckons the Office of Financial Research (OFR) will need to craft an identifier that contains a suitable coding sequence in order to be able to relate the entity to other related entities and instruments. The remit of the new agency is, after all, to better track systemic risk, he explains to Reference Data Review.
This month has seen a lot of feedback to the OFR on the subject of entity identification, but Liegel is concerned that some may be missing the point. “The identifier will need to allow for systemic risk tracking rather than individual firm level risk tracking,” he explains. “It will therefore need a suitable coding sequence in order to be able to relate this entity to other events and entities and provide value to the industry and regulators in the long term.”
He highlights the fall of Lehman and the struggles thereafter to track counterparty risk as proof that a lot must be done at the systemic level, rather than an individual firm level, in order to facilitate better oversight of the markets. “The big thing around Lehman was looking at how some of the counterparty information had been standardised and seeing whether or not they have the same risks, or similar risks. This is especially important in terms of lending and leveraged markets,” he says.
Liegel indicates that FRSGlobal has also been working on determining how financial contracts are mapped so that they can be compared across the spectrum of functions within a firm. He explains that a number of factors must be taken into account, for instance for a loan there is a relationship between an obligor and a creditor, which is very different to the dynamics for an equity holding or a derivative. “We have done a lot of work within our own risk systems to model those in order to compare like with like. So if there is a financial event, we compare how that event changes the valuation of an instrument and the corresponding cash flows,” he elaborates.
The derivatives space is a particularly challenging one in this regard: “One of the really big problems with the credit default swap (CDS) market was that it is unknown to the regulators who really owns them. Because they are traded OTC most of them do not go through a central regulator, hence it took many months for the examiners to unravel what was behind the CDS related to Lehman.”
In terms of financial instruments, Liegel therefore reckons one of the biggest things that regulators are going to mandate with the legal entity identifiers is coming up with a way where they can quickly link those entities together. The key is therefore to create an identifier that facilitates the linking of these different entities, he continues.” Once an identifier is created, how do you track the extent to which they have financial commitments? If the identifier doesn’t facilitate that, then it won’t have too much value to the regulatory community,” he argues.
But how are the regulators going to be able to track systemic risk using these identifiers? That is what the OFR was set up to do, so it will need to see global data on holdings by different financial institutions. There will also need to be more cooperation between US regulators in order to ensure firms such as AIG are covered by the new legal entity identification standards and systemic risk tracking, continues Liegel.
However, being able to design an identifier that covers all these different financial institutions, which all perform different functions, will be a challenge. The tracking of the risks related to the activities of insurance firms for example, is different to tracking those of a bank. It will therefore be a significant challenge for any vendor to be able to provide an identification standard that allows the tracking of these risks in a timely manner, he reckons. Currently, it can take days or weeks to track these entity linkages and related risks, but regulators and firms need to be much faster in this endeavour.
As for the industry, Liegel notes that large commercial lending operations are looking at improving their counterparty risk management techniques this year by focusing on finding out the correlation of their exposure to different firms and financial instruments. Large banks and trading firms will therefore be creating their own identifiers to this end. “What the OFR needs to find out is what data it will need above and beyond the individual firm level, to be able to determine firm to firm correlation,” he adds.
FRSGlobal itself maps financial contracts data and follows the cash flows on top of these contracts, which allows the vendor to be able drill down into the end data, says Liegel. The vendor uses a data warehouse on which to build its risk analytics functions and has therefore been engaged in the mapping process between instruments and entities. He indicates that the vendor will be doing more this year to move from an aggregated data standpoint to a much more granular level across all of this data.
As for the near future, Liegel doesn’t believe that the US will be much ahead of the rest of the world in terms of data standardisation, in spite of the OFR discussions. He notes that regulatory change in the US is often a very slow process and points to the slow adoption of Basel as a case in point. He also reckons that the UK Financial Services Authority (FSA) is ahead of the US regulatory community in many respects, especially with regards to the monitoring of the buy side community.
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