March 2012

COMPLIANCE: A question of identity

PalmNicholas Pratt looks at the potentially profound implications of the LEI initiative, its aim to provide clarity and transparency to the financial markets and what it means for fund management firms.

Investment managers face an avalanche of compliance commitments at present – the majority of which are concerned with client reporting. Some loom large on the horizon – such as Solvency II, Ucits IV and the Foreign Account Tax Compliance Act. Other reporting initiatives are less prescriptive – as seen in the various efforts to establish standards for sustainability reporting. But perhaps the one reporting project with the most profound long-term implications for every participant in the financial markets is the legal entity identifier (LEI) project.

The LEI initiative is an attempt to create an indelible tag for every legal entity involved in a securities transaction. The idea is being spearheaded by the US Treasury’s Office of Financial Research – a macro-prudential body designed to oversee the management of systemic risk, analogous to the European Central Bank’s European Systemic Risk Board. But it has gained international support from regulators and participants alike.

It is not the first time that an industry-wide identifier scheme has been attempted but the LEI is aided by greater international co-operation and a recognition that a situation such as that which followed the collapse of Lehman Brothers, where market participants were left unsure of whether they were exposed or not because of poor counterparty risk practice, should never be allowed to happen again.

Unsurprisingly, the traditionally opaque over-the-counter (OTC) derivatives market will be the first to use LEIs. The US-based Commodity Futures Trading Commission (CFTC) has mandated their use for the reporting of credit default swaps. The first tranche is expected later this year for the 12,500 counterparties involved. It is then expected to be adopted for OTC derivatives reporting worldwide.

Parental guarantee
So what does the LEI initiative mean for fund managers? For any funds that are counterparties in US-based credit default swaps deals, the work will start once the CFTC demand becomes active. But as the LEI project gains ground and becomes adopted by other regulators in different geographies and asset classes, its value will increase, not least because it can form the basis for better counterparty risk management.

“We definitely welcome the LEI,” says Wylie Tollette, director of performance analysis and investment risk at Franklin Templeton Investments. “We undertook our own initiative two years ago to understand who our counterparties were on a global basis and there was a hell of a lot of work involved.”

Most of this work involved checking that the entity provided by the counterparty matched that used internally. That clarity could be assured over the parental guarantee status and respective credit limits could be assigned accordingly.

The European Fund and Asset Management Association has lent its support to the “development of a standard LEI for OTC derivatives data” and the basic principles behind it. Inevitably, Efama also has concerns over the appropriate governance of the system and suggests a single global governance committee “should be responsible for oversight of the LEI solution provider(s), including management and distribution of the data and any additional potential services that the solution provider would endeavour to deliver”.

The potential for LEI-related services from various providers is huge. As Tim Lind, global head of strategy and business development, enterprise content at Thomson Reuters, says: “The LEI is the equivalent of mapping the financial genome. You can then trace all the special vehicles that are owned by an entity. It also enables firms to do so much in risk management terms, particularly in assessing the creditworthiness of an entity and creates an indelible link between the valuations process and also periphery areas such as supply chain risk and sanctions.”

So, given that LEIs are likely to be adopted by various regulators across many international markets and asset classes, is compliance just a simple administration task for fund managers or something altogether more complex?

“It depends on the organisation and whether they have a centralised or decentralised operating model,” says Darren Marsh, business manager – risk management and compliance services at Interactive Data. “Those with a centralised model will find it easier to map the LEI data and then proliferate it out to other departments and avoid repeating mapping processes over and over again.”

Formalising plans
The LEI could, therefore, act as a catalyst for firms to move to a centralised model and Marsh believes data vendors could have a big role to play if this proves the case.

“The LEI on its own doesn’t mean much but if you start packaging it with the data required to perform their daily business functions, especially risk management, it becomes much more important. Firms will expect data vendors to include the LEI in their offerings. Cross-referencing services and packaging information around LEIs. For example, vendors could offer something specific around credit risk, linking the LEIs to credit ratings and corporate hierarchies.”

So what should fund managers that have yet to formalise their LEI plans be doing now?

“I would urge firms to get involved in the process via their industry associations and by responding to the consultation papers. There is an opportunity for companies to review test cases and understand how it will affect them in terms of future application,” says Marsh. For example, in addition to the risk management benefits, the LEI could also be used by fund managers to include within the reports they provide for their own investors.

“In the past six months there has been a lot more interest from investment managers,” says Bill Meenaghan, global product manager for Omgeo Alert, the settlement database developed by post-trade services provider Omgeo. Omgeo has looked to add the LEIs into its alerts at an investment manager and broker/dealer level. Omgeo is also looking to develop LEIs at the fund level, rather than waiting for this to be mandated by regulators.

“There could be a lot involved for investment managers if they have to change or add LEIs for all systems in the transaction process – from accounting systems to order management systems to settlement systems. One thing we are looking at is whether investment managers can use our central matching system rather than changing all of their internal systems.”

An alternative approach being discussed, says Meenaghan, is using the LEI itself as a matching field that can then be bilaterally matched with the relevant broker/dealer, creating a two-way matching process between counterparties based on the LEI, as opposed to merely ensuring that they have the right LEIs in place but knowing little of their counterparties.

Meenaghan expects many buy-side firms to look to their sell-side counterparts to assist them in meeting their LEI requirements, not least because most brokers will typically hold all the necessary data and many managers may feel they have more pressing and detailed reporting requirements to meet right now.

However, as Meenaghan says: “If it was me, I would want to be in control of my own data rather than relying on my brokers.”

This should be especially so, given the potential to use the LEI data for truly beneficial purposes beyond mere compliance.

©2012 funds europe