The idea of universal legal entity identifiers was designed to make counterparty classification straightforward for all regulations. Nicholas Pratt finds critical uncertainty remains as the deadline for over-the-counter central clearing of derivatives looms large
Back in 2011, when the legal entity identifier (LEI) project was presented to the market, the hope was that one globally-accepted and unique standard could be used to classify all counterparties in a financial trade.
This was meant to prevent the kind of tangled mess that emerged following the default of Lehman Brothers.
At best, the LEI could be a central part to a firm’s revamped internal risk management process. At the very least it could be used as the universal standard for classifying counterparties and meeting the trade reporting requirements of new over-the-counter (OTC) derivatives regulation.
However, as the deadlines for these regulations come into effect and the era of central clearing commences, there is still not a fully-formed LEI system.
In January, the LEI Regulatory Oversight Committee (LEIROC) took on the responsibility for developing and implementing the LEI system. It is currently developing a non-profit foundation in Switzerland to act as the central operating unit (COU) but, until this is complete, there is no central body to which firms can apply for their LEI.
Meanwhile, we are left with the interim global legal entity identifier system (GLEIS), in which a number of nationally-based local operating units (pre-LOUs) will act as the interface for awarding so-called pre-LEIs.
So far, there are four pre-LOUs – the CICI in the US, the German entity identifier utility, the LEI France utility and the London Stock Exchange in the UK which started to issue pre-LEIs in August. And as with any interim measures, especially those run at multiple national levels, confusion is rife.
“Everyone’s confused about this,” says Alec Gibson, an analyst at JWG. “I’ve not met anyone who has total clarity.”
One of the pressing priorities is the need for some level of mutual acceptance between pre-LOUs. “The different interim local operating units (pre-LOUs) are not necessarily operating in a standardised way,” says Gibson. “There is an ISO LEI standard but that only guarantees a certain level of harmonisation. In the absence of uniform procedures from the COU, most LOUs have been defining their view of the entity on a discretionary basis and adding additional characteristics as they see fit.”
This was highlighted in June by the European Fund and Asset Management Association (Efama) in a letter to the LEIROC in which director general Peter De Proft wrote of the “critical importance” of resolving these issues as we “enter a period where current and future regulatory reporting will require LEIs at a time when the global LEI system is still under development”.
Fortunately, a meeting in Mexico in June of the LEIROC and 46 national authorities, including the four pre-LOUs, and the subsequent publication in July of the principles to be observed by pre-LOUs has averted a crisis.
“We are confident that the duplication of identifiers can be avoided,” says Rudolf Siebel, managing director of the German Investment Funds Association (BVI). “The LOUs that abide by the ROC’s principles, together with their national regulator, will get a certificate from the ROC so mutual acceptance can come as soon as they get that certificate.”
So in theory, for Dodd Frank reporting, a German fund with a pre-LEI from the London Stock Exchange can do swap business in the US. However, in practice, there is not yet any formal confirmation of such acceptance. The Commodity Future Trading Commission, which governs the swaps market in the US, said it will accept the pre-LEIs from Europe once that Europe agrees to accept the CICI’s pre-LEIs.
Europe has yet to indicate it agrees. So although the framework is there, it is a politically charged situation that has yet to be resolved even though deadlines are passing every day.
Gibson says the stand-off is part and parcel of the EU/US Equivalence Rules, designed to make compliance with either Dodd Franks or rules by the European Securities and Markets Authority (Esma) mutually applicable.
The problem is that both the US and EU have taken different approaches to counterparty identification says Gibson, which means that the LEIs will need to be fit for purpose for a variety of different use cases.
“I believe that is only once the equivalence rules are agreed that we will get mutual acceptance on the pre-LEIs and, therefore, be able to use the same identifier for both Dodd-Frank title VII and Emir [European Markets Infrastructure Regulation].”
Another concern for fund managers is the attribution of LEIs and whether it is the fund or the fund manager that is responsible. It is an issue of diverging national laws, says Siebel where one country’s interpretation differs from another’s. For example, German law may see a contractual fund as a counterparty but Luxembourg law may not. “For Esma, the identity of a contractual fund may be difficult to discern. All contractual funds area approved by regulators even if they are not in a business registry, but there are grey areas such as in the case of a Luxembourg pooled fund so it is a borderline issue.”
Given that it is likely that all funds will require an LEI eventually, it would be convenient if Emir reporting stated that LEIs were attributed to all funds. Unfortunately, the grey area that exists in certain fund structures means that a unilateral ruling may prove problematic, says Siebel.
“Esma should simply state that all funds for all asset managers should get an LEI because they will need to do that in the long term anyway for shadow banking requirements or for the Alternative Investment Fund Managers Directive. Furthermore, the concept of a single identifier would have use beyond simply Esma regulation but also for internal risk management and know-your-customer requirements. But if contractual funds get the impression through Emir that they do not require an LEI, that will create uncertainty.”
One of the problems, says Tim Lind, Thomson Reuters’ global head of middle office, is that the initiatives are happening at different speeds. “The reform of the derivatives market is outpacing the establishment of the LEI system.”
Derivatives reform has been driven by urgent public policy and the need to be seen to be doing something whereas the LEI initiative has a governance structure that operates at a slower pace. “A trade-off was made two years ago when the LEI was being formed,” he says. “It chose a federated model that would be politically inclusive and involve as many countries as possible. This will mean greater global adoption of the LEI but the downside is it creates a complex interim framework of LOUs. It needs a body to co-ordinate all that activity but it will take time to develop that body (the COU).”
At the outset of the LEI initiative there were debates about the level of granularity needed for LEI attribution, especially in the funds world. For example, a fund will invest in different share classes so should the LEI be attributed at a share class level?
Pragmatism ruled against the share class attribution but we are now seeing similar debates about certain fund structures. While this uncertainty is unhelpful, Lind says it is important to look beyond the technical especially for trade reporting obligations under derivatives rules and for identifying counterparties, he says that these technical issues should not be allowed to hinder progress of the LEI initiative.
“At Thomson Reuters, we have been involved in the mapping of thousands of LEIs and we have seen some of them deleted as the rules change, which is frustrating. But I still believe that these technical issues will be resolved and they should not diminish the validity of the LEI initiative.”
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