How using LEIs can help prevent another financial crisis

The 10-year anniversary of the Lehman Brothers collapse and onset of the global financial crisis has largely focused on the question of whether we are safer and better prepared to handle such an event today.

Most pundits commenting on those dark days in September 2008 seem to agree that the global financial system is more robust than it was a decade ago, with financial institutions and governments better positioned to withstand a similar shock.

However, there are still holes in the regulatory defences that require action to address. Foremost among them is the patchy adoption of legal entity identifiers (LEIs). The LEI was designed to enhance transparency in markets. Essentially the identifiers help regulators and financial firms quickly and accurately identify which entities own what, and who is who. This may sound simple, but much of which was a mystery in the days and weeks after the Lehman collapse. 

The identifiers were also conceived to help companies improve the internal risk management processes associated with collecting, standardising, aggregating and reporting their data while improving efficiency, thereby reducing costs. This has become increasingly important in today’s environment, where LEIs could decrease the touchpoints that drag on the trade lifecycle.

The use of LEIs is currently mandated under Markets in Financial Instruments Derivatives II (Mifid II) in the European Union and for global transactions that involve an EU counterparty. At the same time, the system has been adopted by a number of key US regulatory agencies. 

SLOW UPTAKE 

In Asia, adoption of LEIs has lagged. Japan and Australia have pushed ahead with mandating LEIs in the over-the-counter (OTC) derivatives space and Hong Kong will require their use from April 2019. Meanwhile, Malaysia has adopted LEIs to identify payees/payers in an attempt to cut down on fraudulent behaviour. 

However, the numbers reveal that this represents just a small portion – only slightly more than 4% of the 1.3 million LEIs globally have been issued to entities in Asia. There are many potential reasons for this. Some banks and financial institutions in the region do not have exposure to European counterparts, and thus may be unaware of the LEI or see little need for it. 

At the same time, many corporates and non-financial institutions in Asia have been slow to sign on to the regimen. Some of these companies are subject to national identity schemes that proliferate in Asia’s fragmented regulatory regimes – including the Broker-to-Client Assigned Number in China and Hong Kong or other dedicated financial institution ID systems – that do not extend beyond domestic markets. 

Whatever the reasons for Asia’s slower uptake of LEIs, lack of adoption in the region represents a vulnerability in the global defences against a replay of the 2008 financial crisis. Anything short of universal adoption of LEIs limits the system’s ability to protect financial markets and deliver process and cost efficiencies.

ENCOURAGING LEI ADOPTION

In recognition of the persistent issues at a global level, the Financial Stability Board (FSB) is currently looking at ways to encourage LEI adoption. In August, it announced a peer review seeking to: 1) gather global input on the approaches and methods used by FSB members to implement LEIs, including its adoption for regulatory requirements; 2) assess whether current rates of LEI adoption are sufficient to support the ongoing and future needs of FSB member authorities; and 3) identify the challenges in further advancing the implementation and use of LEIs and make recommendations to address common industry challenges.

The industry’s use of LEIs has progressed significantly and DTCC is actively working to expand this use through its GMEI utility which, having issued over 407,000 LEIs, is the largest issuer regulated by the Global LEI Foundation (GLEIF). 

Beyond regulatory concerns, LEIs – especially when used with standing settlement instructions (SSI) – could reduce the friction that slows post trade processing by seamlessly connecting transactions and counterparties across the trade lifecycle. 

In fact, an analysis by GLIEF and McKinsey & Company determined that banks that adopt LEIs have the potential to save at least 10% of total operations costs for client on-boarding and trade processing. 

However, the full benefits of this system – for the public and the private sector – can only be achieved if it is adopted universally.