By Eugene Ing, Executive Director, GMEI Product Management, DTCC.
The 2008 financial crisis highlighted the significance of counterparty risk to the safety of the global financial system. In particular, it demonstrated the importance of identifying ownership structures of legal entities engaged in financial transactions.
To create greater transparency in the global financial system, in 2009, G20 leaders tasked the Financial Stability Board (FSB) with the role of delivering recommendations on the creation and implementation of a unique global identifier for parties to financial transactions called the Legal Entity Identifier (LEI). The objective of this code was to help organisations answer three questions:
- Who is the counterparty in a transaction?
- How does that counterparty look in terms of the broader organisational hierarchy?
- What assets do they own?
In 2019, with roughly 1.5 million LEIs, the FSB’s Thematic Review on Implementation of the LEI put regional coverage as low as 2% to only as high as 7%. In 2022, with 2.2 million LEIs, it is clear the system continues to fall short of coverage expectations.
Fast forward to 2022, the Bank of England’s (BoE’s) Post-Trade Task Force recently published its report, ‘Charting the Future of Post-Trade’, proposing clear recommendations on how to boost the use of LEIs across financial markets to create the transparency and risk mitigation that the G20 originally envisaged with the creation of the global LEI.
First, the BoE report encourages the use of LEIs earlier in the trade lifecycle, such as at the point of execution, which would entail the entity placing its LEI on the transaction with either the broker or trading venue. Thereafter, the order would also include the LEI of the executing broker.
This would help to ensure that both parties are clear, not only at the outset, but throughout the lifecycle of the trade on the identity of the legal entity they traded with. This level of transparency and accuracy can help mitigate operational errors and prevent any downstream issues as the transaction passes through post-trade pre-settlement processes. The report recommended that for this approach to be effective, it would need to be adopted widely among relevant market participants.
Second, the BoE report highlighted that to incentivise the use of LEIs, metrics should be published identifying which market participants are not using LEIs earlier on in the trade lifecycle. It also advocated that market leaders highlight that the use of LEIs earlier in the trade lifecycle is a best practice approach to encourage adoption industry wide.
At DTCC, we support these recommendations and believe that there should be broader adoption of LEIs across all asset classes and, more importantly, from the point of trade execution.
Today’s challenge is not just about broadening the use of LEIs as entity reference information, it is also about harmonising its use across different asset classes, across different regulatory regimes, and across different functions as was originally envisioned by the FSB.
Finally, there are wider benefits to LEIs, such as increasing operational efficiency touched on earlier. An analysis by the Global LEI Foundation (GLEIF) and McKinsey & Co determined that broker dealers that implement LEIs may achieve cost savings of at least 10% of total operating costs for trade processing, as well as client onboarding. These costs savings are achieved by a reduction in resources spent solving problems associated with counterparty identification and, as the BOE report points out, costs associated with misallocation post trade.
LEIs were established to mitigate counterparty risk and increase transparency between entities in financial transactions. However, LEIs can only fully serve their purpose if they are widely adopted. We hope the recommendations on LEIs from the BOE’s Post Trade Task Force will spur market participants that have not yet adopted LEIs at all, or earlier enough in the trade lifecycle, to do so as soon as possible. Doing so can protect individual firms, as well as mitigate counterparty risk, thereby enhancing transaction safety and protecting financial markets.
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