Financial regulators need to fix the plumbing first
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The financial crisis and its aftermath have fostered an unprecedented number of regulatory requirements on the major financial institutions of the world, while, at the same time, they must adjust to the new technologies of the digital age.

The lessons of the financial crisis taught us that global financial institutions transcended sovereign boundaries of regulation and that the ability of regulators to observe risk building up in the financial system is critically dependent on accurate, timely and aggregated financial transaction data. A more fundamental observation is that the discipline of risk management had for too long neglected improvements in data management.

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Now the Trump administration has the chance for a regulatory redo within the new order of a global, information-based financial system. It needs to harness separate regulatory efforts into a cohesive integrated plan lest we fall behind others, who were previously less advanced but now take advantage of the newest technologies to advance their markets and banking systems. 

 

New regulations have generated new and significant demands for data transparency and data management at both the financial institution and regulatory level. However, in the U.S., there is still no understanding of how to operate, interconnect or reconcile the financial system’s legacy technology and operational obsolescence with its lightspeed straight-through-processing automated future. 

The response in the U.S. has seen many experiments with narrowly focused solutions but no consensus on using the new technologies for fundamental redesign. The most "advanced" thinking on fundamental redesign is epitomized by the Securities and Exchange Commission's (SEC) Consolidated Audit Trail (CAT) system, a next-day accumulation of financial transactions related to stocks and options, and the security industry’s move to a two-day settlement and payment system from today’s three days.

Both of these are yet to be implemented and yet, when finally implemented, will be well behind the already understood need to observe and mitigate the risk of trading already done in real-time.

To the credit of some regulatory agencies, notably the Office of the Comptroller of the Currency (OCC) and the Commodity Futures Trading Commission (CFTC), they are providing regulatory freedom for technical experimentation by non-regulated financial technology start-ups, as well as existing regulated financial entities.

However, still left to do is a future-facing architecture for the fundamental redesign of the whole of the United States' financial infrastructure in the context of its relationship to the global financial system and its digital future.  

One of the least understood issues of the rethinking of finance’s digital future is the linkage of risk management with data management. Required is an understanding of complex interactions over multiple financial market participants and other financial industry stakeholders.

These other stakeholders include non-financial intermediaries, like corporate issuers of securities; hedgers and corporate users of contract markets; participants in currency markets; commercial trade parties that utilize the financial industry’s payment and settlement systems; global and sovereign government agencies and financial ministries; infrastructure utilities; regulators; computer, communications and software companies financial transaction and economic data vendors and distributors. 

How this complexity is understood and managed by the senior management of financial institutions is important to regulators, so much so that the largest of them have been designated Systemically Important Financial Institutions (SIFIs) and are the subject of an overwhelming number of compliance and regulatory mandates.

It is further understood that without an ability to view their holdings and cash flows, valued in standard ways and aggregated by counterparty through common identifiers, neither risk triggers nor risk exposures can be observed nor can systemic threats be detected in any timely way. 

It has been accepted by regulators that the very first pillar of global financial reform is a standard for identifying the same financial market participant to each regulator in the same way. This legislation was inspired by the revelations arising from the Lehman Brothers bankruptcy.

Lehman was observed to have had no consistency in identifying itself as a counterparty with others; no understanding of what relationships it had with others and no mechanism to associate all of its products and businesses into a total view of the exposure it had within itself or with others should it fail.

It wasn’t just Lehman; it was a fundamental flaw in the infrastructure of the global financial industry. The industry could not aggregate risk because they had no universal identification of counterparties or their hierarchies of business ownership. They also had no universal identification of the products they owned or the collateral they had pledged.

The G20’s new global standards setter, the Financial Stability Board (FSB), has been tasked with creating the framework for a unique, unambiguous and universal identification standard for financial market participants and their products and transactions. These identifiers are then to be embedded in financial transactions and used by both regulators and industry members in automating regulatory reporting and in straight-through-processing (STP).

STP has long been the unfulfilled vision of the financial services industry, described as the means to completely automate the lifecycle of a financial transaction.

Another global standards setter, the Basel Committee on Banking Supervision (BCBS), has advocated their use in aggregating data for the reporting of risk. Some sovereign and regional regulators have incorporated these ID's into their own regulations.

The objective for the deployment of this global ID regime, as stated by regulators, is to aggregate financial transactions to observe a single firm’s enterprise risk and multiple firms’ systemic risk across the globe.

In light of the near fatal collapse of the financial system, it seems fundamental to get on with fixing the plumbing of the financial system. Every U.S. regulator and the largest of financial institutions should sit around the table, sponsored by the Trump administration, and get on with this task in an organized, integrated way.

Allan Grody is the president of Financial InterGroup Advisors — strategists, consultants and researchers in financial services with particular focus on bank regulation and the design and implementation of innovative enterprise solutions. 


The views expressed by contributors are their own and not the views of The Hill.