What scarcely appears to merit a footnote may be regarded as the time of birth of a new global financial market infrastructure. It is the overdue response of the community of nations to a classic market failure. Its governance structure attempts a double balancing act between public supervision and private execution and between central management and decentralised responsibility. Its success will depend on the future acceptance of the LEI.

Market inefficiency

In simple terms, identifiability means being able to obtain material information on market participants at low cost. If such information can be retrieved under an ID number, this is known as reference data. Those seeking it may be market participants, supervisory bodies or the general public. If every market participant has its own ID, it is the key to all the information that is available on this market participant. This minimises the acquisition costs and makes individual reference data more valuable since they can easily be aggregated to give a meaningful overall picture. In short: a unique ID enhances efficiency.

Things look different in reality. For instance, if market participant A has granted a loan to market participant B, before it lends to market participant C it will want to know whether B and C are members of the same group and whether A has already lent to market participants B or C before (keyword: cluster risk). But for banking groups that have gone through many mergers, creating thousands of subsidiaries, it is quite common for a client that may for its part consist of many group companies to have several IDs. In addition, the reference data that are available frequently provide no information on group relationships. As a result, answering even trivial questions on such matters as mutual lending, guarantee and derivatives relationships becomes the Achilles heel of any risk management system. The creditors of the bankrupt Lehman group, its home country supervisors and the taxpayer could tell you a sorry tale about that.

State intervention

Market intelligence services have not been able to solve this problem. As profit-oriented undertakings, their primary interest is in tying clients to them through proprietary standards and licensing agreements instead of creating an open, market-wide identification standard together. Typical licensing agreements even prohibit combining proprietary ID numbers and associated reference data with information from other sources.

In order to make identification more efficient, state intervention was therefore necessary. The US legislature led the way: in 2010 it adopted the Dodd-Frank Act, which among other things requires the creation of a Legal Entity Identifier for trading in over-the-counter (OTC) derivatives. Then in 2011 the G20 instructed the Financial Stability Board (FSB) to draw up a plan for establishing a LEI that would apply world-wide. This had been largely implemented by 30 June 2014.

Architecture of the global LEI system

In June 2012 the FSB and the G20 Heads of State and Government adopted General Principles for a global LEI system and in November of the same year the LEIROC Charter. Accordingly, the LEI system serves to provide a globally unique identification of all legal entities and other organisations operating on the financial market, such as investment funds, for instance. Natural persons do not fall within the scheme and neither do dependent branches, even though it might be useful if these could be identified as well. The LEIROC intends to plug this gap in the medium term.

LEI ID numbers and reference data have been defined in accordance with ISO Standard 17442. In essence, the reference data contain only the name and the addresses of the registered office and head office of the legal entity, its legal form and country of establishment and, if available, the name of the public register in which the principal place of business is registered. The LEIROC is working on recording company law and other relationships (relationship data) as well, but is struggling with the inventiveness of market participants and lawmakers that manifests itself in contracts and in the national company law of different jurisdictions. Opposition could also come from the big market intelligence services, which are already offering similar though fee-based services and are against new competition.

Governance

The global LEI system is divided vertically into three levels. The top level is occupied by the LEIROC, which as the international oversight body is meant to enforce the public interest. Its operational counterpart at the second level is the Central Operating Unit (COU). Legally, its sponsoring institution is the Global LEI Foundation (GLEIF), a foundation established under Swiss law. At the third level are the decentralised Local Operating Units (LOUs), which allocate and maintain the LEI codes and reference data.

The global monopoly position of the LEI system and the market power of individual LOUs on geographical sub-markets is counter-balanced by the governance structure, competition between LOUs, open access to the LEI database and the prohibition on earning profits. Companies have a free choice of LOU and can transfer their LEI to another LOU at any time free of charge. There is in principle nothing to stop LOUs from competing for clients world-wide provided the quality of the reference data is not impaired as a result.

Competition among LOUs is, however, weakened by two factors. Firstly, the prohibition on earning a profit hinders the accumulation of capital for innovations and thus cost efficiency. Secondly, the two largest LOUs, the US Depositary Trust and Clearing Corporation (DTCC) and the German WM-Datenservice, with market shares of more than 50% and 15% respectively, have considerable market power. The concomitant risk of private-sector organisations influencing the central bodies GLEIF and the LEIROC is reduced by the fact that the Central Operating Unit is a foundation. In addition, its founder is the FSB – an international supervisory institution backed by all the major industrial nations. However, since the Foundation’s expenditure has to be funded mainly from cost-allocation contributions from the LOUs, the preservation of its independence, in the public interest, will remain a permanent challenge.

The functioning of the LEI system must be guaranteed even in exceptional circumstances. In addition to the usual operating risks, it is also conceivable that an LOU will fail, for instance, because it becomes insolvent or because following a breach of the rules it is stripped of its status as an LOU. In such cases the LEIs registered with it will have to be transferred to a functioning LOU. Resultant contractual problems in the relationship between the LOUs concerned and the clients in question are largely unresolved.

The Oversight Committee

The LEIROC is the supreme decision-making body of the LEI system. It was set up in January 2013 as a political association whose members by now number more than 60 national and international supervisory institutions and central banks. Germany is represented by BaFin and the Bundesbank, the EU by the Commission, the European Central Bank and the three European Supervisory Authorities – the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA).

The Committee sets quasi-legal and technical standards which are intended to ensure that the system functions properly and adapts to new requirements. As an oversight body, it also seeks to ensure that the Central Operating Unit and the Local Operating Units comply with the standards. It also sends non-voting members to the Board of Directors of the Foundation.

Although the LEIROC cannot issue binding instructions, since this would diminish the Board of Directors’ decision-making capacity guaranteed under foundation law and would also mean a liability risk for the LEIROC and its members, the Foundation is fully accountable to the LEIROC. In addition, it is subject to Switzerland’s foundation supervision. The LEIROC member of the home country of any LOU (sponsor) may, in consultation with the Foundation, enforce LEIROC decisions against it. Where there is no legal basis for this, it is done informally. Upon application, the LEIROC also recognises undertakings or national public bodies as LOUs. However, this function is to be taken over by the Foundation as soon as it is in a position to do so.

LEIROC’s decisions are approved unanimously. An Executive Committee, to which members are appointed by proportional geographical representation, conducts the routine business and decides in cases which are not of fundamental importance. Technical preparatory work, especially for standard-setting, is carried out by a committee set up by the LEIROC, the Committee on Evaluation and Standards (CES). In this, it cooperates closely with the LOUs.

The Global LEI Foundation

The Global LEI Foundation was established on 26 June 2014. The German member of its Board of Directors is Prof. Dr. Wolfgang König, Executive Director of the House of Finance at the Goethe University in Frankfurt am Main (see Interview).

The Foundation manages the Central Operating Unit. It will create a freely available database in which all LEIs are registered and will update this on a regular basis. Furthermore, by means of data analyses but also on-site audits it will verify whether the LOUs are complying with the LEIROC standards. Finally, it is expected to play a major role in the development of future standards.

Decentralised local operating units

So far the LEIROC has recognised 17 LOUs worldwide, of which two in Germany (WM-Datenservice and Bundesanzeiger-Verlag). The ID numbers that the recognised LOUs are issuing are valid LEIs which can be used, for example, to meet statutory reporting requirements. However, the Foundation will still verify this recognition. The precise procedure is still being determined. For that reason the units should also still be referred to officially as “pre-LOUs“ – i.e. provisional local operating units.

The LEI system’s LOUs bear the main burden of its operations. One key element of their work is the validation of the reference data provided by market participants, which have to be kept up-to-date throughout the lifetime of the LEI. The LOUs charge undertakings fees for this, both for the initial registration and for the annual renewal. Out of this income they must also pay the cost-allocation contribution used to fund the Foundation.

Other areas of application

As a market infrastructure, the LEI system offers only an identification service. Thanks to network effects, its value will increase with the number of users, while its charges will fall due to economies of scale. The critical mass from which the system becomes a self-sustaining success cannot be achieved unless there are corresponding regulatory requirements.

At present LEIs are mandatory mainly in derivatives trading. But in some countries there are already initiatives under way to use it in other areas of financial market supervision as well. According to a recommendation from the EBA of January of this year, for instance, credit institutions would have to identify themselves in their reports to national supervisory authorities by using their LEI. EIOPA is at present conducting a consultation on guidelines for insurers, re-insurers and occupational pension scheme providers. And if a Technical Regulatory Standard drafted by ESMA on the recently amended EU Regulation on Rating Agencies is adopted, issuers without a LEI will no longer be able to obtain a rating in future. The European Parliament has also proposed using LEIs to cast light into the darkness of shadow banking.

In other areas, however, acceptance still leaves something to be desired. That is definitely the case in some countries outside Europe. It is therefore imperative that private self-regulatory organisations, national lawmakers and international standard-setters scrutinise the regulation of financial and other markets systematically, in order to identify areas in which the introduction of LEIs would cut costs and reduce systemic risks. Furthermore, market participants should integrate the LEI into their internal processes. Only in this way can the potential of this new market infrastructure be fully realised.

Interview with Prof. Wolfgang König: “Spots on the global risk map”

Prof. Dr Wolfgang König, German member of the Board of Directors of the Global LEI Foundation, Executive Director of the House of Finance at the Goethe University in Frankfurt am Main

Professor König, it was in October of last year that you were appointed to the Board of Directors of the Global LEI Foundation on the recommendation of BaFin and the Deutsche Bundesbank. But it was not until the end of June that the Foundation was actually established. Why did it take so long?

Although at that time we did have the mandate from G20 Heads of Government to establish a foundation, various high-level principles issued by the Financial Stability Board (FSB) and extensive further thoughts from the Regulatory Oversight Committee (ROC), the oversight committee for the LEI system, we did not have any money or a viable business plan. Operationally, we had to start virtually from scratch. In addition, the sixteen members of the Board of Directors come from four continents and have quite different cultural and professional backgrounds – think public-private partnership. There was therefore also a need first of all to develop a common idea of our functions and possible solutions.

Where do you see the biggest difficulties for your work?

First: data quality. The Local Operating Units (LOUs), which assign the Legal Entity Identifiers – LEIs for short – are spread all around the world. The technical standards which are supposed to unite these local units into an organic whole were and still are incomplete. It was only a few weeks ago that the Oversight Committee adopted a standard that will facilitate the exchange of data. Intensive discussions are now taking place on a suitable integration of the LOUs’ data sets into common Global LEI Foundation databases. At present that requires too much manual input. Quality assurance will definitely keep us busy for quite a long time to come.

Second: the conceptual design and thus also the funding of the Central Operating Unit. Originally it had been hoped to receive generous start-up assistance in the form of donations. That didn’t work – the Foundation is having to manage with cost allocation contributions from the local operating units. At the same time it must take care that its independence is preserved, for it is after all supposed to be overseeing the LOUs.

What will the Foundation be using the income for?

In accordance with the initial business plan approved by the Oversight Committee, it will create an IT and governance infrastructure so that all registration units deliver externally audited and, ideally, equal data quality. We need sophisticated communication protocols between the central and the local units, such as SWIFT has been using for decades for money transfers between banks. And we must ensure through regular on-site audits that the local units are complying with international standards – which also includes risk management and regulatory obligations.

Some local operating units think that the contributions they are being called upon to pay are too high. Is that justified?

No. The large number of functions and the conceptual challenges must be managed by a qualified team. Incidentally, neither the local operating units nor the Central Operating Unit are allowed to make a profit on providing LEIs. Our budget is approved by the Oversight Committee. It is based strictly on the public-interest purpose of the LEI. And I will never tire of saying that the LEI will enable the financial industry to save a lot of money on risk management and data management, not to mention the system-stabilising effect. After all, to pick up the image of the Issing Commission, LEIs mark the spots on the global risk map, as it were.

If the LEIs mark the spots on the risk map, what are the streets?

The risks that participants on the financial market assume from, for example, derivatives, large exposures and group interrelationships. It is the duty of international standard-setters and national lawmakers to enter the streets on the map, i.e. to set the LEI for individual types of financial transactions. We’re already a fair way down that road in the EU. The LEI is mandatory in derivatives trading. In future all reporting requirements under the new Markets in Financial Instruments Directive (MiFID II ) will also be able to be met only by using LEIs. The European Banking Authority (EBA) demands it for certain reports from credit institutions; the European Insurance and Occupational Pensions Authority (EIOPA) is thinking aloud about making the LEI compulsory for reporting under the new supervisory regime Solvency II. These are only a few examples. Outside Europe, on the other hand, LEI legislation is still thin on the ground. The Securities Exchange Commission in the USA, for instance, has never required the LEI so far. A further important dimension of the use of LEIs is its private application – for instance, for the Uniform Customs and Practice for Documentary Credits of the International Chamber of Commerce in Paris.