Global ID standards can help prevent the next Lehman Brothers

Global ID standards can help prevent the next Lehman Brothers
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With all the recent talk among legislators  and within the Trump administration about how to reform financial regulations, one thing has been overlooked — the necessity of continuing participation in global transparency standards initiated by the Financial Stability Board (FSB).

Without global data standards for identifying financial products, financial participants and financial transactions regulators will be blind to systemic risks building up in the financial system.

What appears as a simple exercise to aggregate financial transactions to understand the risks of a financial institution, for example, the risks that Lehman Brothers was exposing the global financial system to, turns out to be impossible without data standards.

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This was demonstrated when Lehman failed and no one could understand who was affected and how severely. Each separate financial counterparty in a transaction with Lehman identified Lehman in their computer systems differently.

 

Each financial product sold by Lehman to a financial counterparty, likewise, identified that product in their computer system differently. Further complicating this was a similar issue with regulators, they too had no consistent identification standards.

That led to an inability to see a global picture of the risk Lehman had with its counterparties or that financial counterparties had with Lehman.

Lehman’s failure was a wakeup call that the financial industry does not have a consistent or uniform global standard for either identifying a financial market participant nor the products that they trade, process or own.

Recognizing this, in 2009 the G20, a global body of leaders of the world’s leading economies, empowered a new standards entity, the Financial Stability Board (FSB), to oversee global financial stability. The FSB in turn has the top financial regulators of the G20 as its members, including the U.S. Treasury, Federal Reserve and Securities and Exchange Commission.  

One of the FSB’s key first initiatives was to establish common globally unique computer readable codes for financial market participants, financial instruments and financial transactions. These identifiers were then to be embedded in financial transactions and used by both regulators and industry members in automating regulatory reporting and in streamlining and reducing processing costs.  

Lost in the debate over the U.S. giving up its sovereignty to the Financial Stability Board in matters of financial regulations is the reality of being but one part, albeit one of the largest parts, of a global interconnected financial network underpinning a global economy.

The least common denominator in global financial stability is the willingness of the U.S. and the other G20 member states to conform to an international order of financial data standards.

That most legislators and politically appointed regulators understand this issue is certain. What is less certain is how they can fund the updating of their legacy technology systems to accommodate the new data standards.

One example of the problem is the Commodity Futures Trading Commission (CFTC) reallocation of an incremental increase in its technology budget to deal with immediate compliance issues for new regulations it was mandated to oversee.

The CFTC would be one of the regulators that would be most served in its oversight role if it had the budget to fully embrace the new data standards.

Managing risk either as a financial institution or as a regulator requires knowing what financial institution or non-financial counterparty is at risk; what risks that entity is imposing cumulatively on the parent entity; and which of the financial products or contracts owned by that entity is putting that entity and its parent at risk.

Further, global financial institutions have to aggregate that risk across all business units and across all global locations. This requires the same identity standards to be used to accumulate both the same counterparty owning the same product or contract and to accumulate all counterparties within its controlling parent entity.

This has been accomplished to date in a most inelegant way, using hundreds of proprietary data standards in a very costly, risk-prone mapping (matching) and reconciliation exercise. Implementing global data standards promises to eliminate this exercise.

Regulators in the home country of a global financial enterprise oversee the risk of the entire global entity, relying on the financial institution to aggregate its risk properly.

As each global financial entity is overseen by a sovereign regulator, there has to be some means to aggregate multiple financial institutions’ risk into a global view to determine the appearance of the "contagion of systemic risk," the term used to describe the event that brought on the financial crisis of 2008.

However, there has never been a capability to oversee the cumulative risk of the major systemically important global financial institutions. Being able to observe systemic risk is the important end state of the work the FSB is spearheading in their data standards initiative.

The FSB, as the highest-level bully pulpit for regulatory initiatives, is seen as the solution to the collective action problem: no regulator or financial institution willing to sublimate its self-interest to the common interest.

Compelling regulation is the only way to assure every affected party commits the resources to get this done, or it will never get done.

U.S. legislators and the Trump administration may want to declare America's sovereignty from the Financial Stability Board’s global financial regulatory standards, but not adhering to global data standards should be off the table.

It’s the most important, yet non-threatening global regulation to the United States' concern of maintaining sovereignty over its financial institutions. With proper budgets for the technology upgrades required, it will allow U.S. regulators to see risks building up in the global financial institutions they are mandated to oversee.

For financial institutions, it will spur technology innovation through finally removing mapping and reconciliation processes that impose unnecessary operational risk, impede straight-through processing and cost the global financial industry a quarter-trillion dollars, annually.

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