Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The Dodd-Frank Wall Street Reform and Consumer Protection Act established the Office of Financial Research and provides it with the authority to collect data to support the Financial Stability Oversight Council, or FSOC,  and to set standards for reporting such data.  To support the FSOC in identifying connections among market participants and monitoring systemic risk, the Office of Financial Research intends to standardize how parties to financial contracts are identified in the data it collects on behalf of the FSOC. The Office of Financial Research has issued a statement of policy regarding its preference to adopt through rulemaking a universal standard for identifying parties to financial contracts that is established and implemented by private industry and other relevant stakeholders through a consensus process.  The Office of Financial Research seeks comment on a statement of policy, including but not limited to the desired characteristics for a Legal Entity Identifier, or LEI, and the institutional arrangements for issuing and maintaining identifiers and associated reference data.

 The Need for a Universal Standard for Identifying Parties to Financial Contracts

Precise and accurate identification of legal entities engaged in financial transactions is important to private markets and government regulation.  In the private sector, data identifying counterparties support communication between systems, facilitate transaction processing, and allow for accurate aggregation of positions vis-a-vis individual or classes of counterparties, which is necessary for effective risk management and calculation of margin.  Sales, compliance, and due diligence functions also rely on unique identification of counterparties.  In the public sphere, correctly identifying parties to financial contracts is critical to assessing the connections among financial firms and to monitoring systemic risk.

 There is currently no universal system for identifying the legal entities that participate in financial markets.  In the absence of such a system, private firms and regulators have created a variety of identifiers.  This creates inefficiencies for firms and presents obstacles to regulators and policymakers.

 At private firms, because there is no industry-wide legal entity identification standard, tracking counterparties and calculating exposures across multiple data systems is complicated, expensive, and can result in costly errors.  For example, maintaining internal identifier databases and reconciling entity identification with counterparties is expensive for both large firms and small firms.  Complete automation of back-office activities remains elusive, in part because of the lack of a universal identifier for legal entities. In the worst case scenario, transactions are broken or fail to settle because counterparties have not been properly identified.

 The lack of a universal identification standard also poses problems for regulators and policymakers.  For example, precise identification of financial firms is necessary to evaluate whether a firm poses a systemic risk, which involves the assessments of the relationships among firms operating across a range of markets.  Indeed, the problems that firms face in aggregating exposure are magnified in measuring risk across the system.  In addition, securities regulators must often identify parents and affiliates of broker-dealers manually and by name.  Multiple and generally different identifiers for participants in securities trading make it difficult to create a consolidated order audit trail.

 Statement of Policy

 In support of the FSOC’s duties to identify and assess risks and potential threats to the stability of the U.S. financial system, the Office of Financial research, in consultation with the Chairperson of the FSOC, intends to establish requirements for reporting data on financial contracts to the Office of Financial Research that include a standardized way of identifying counterparties.

 In establishing such rules the Office of Financial Research would prefer to adopt a universal standard developed and implemented by the financial industry and other relevant stakeholders through a consensus process. In addition, the Office of Financial Research believes that participation of international standard setting bodies would be beneficial in developing a standard that can be used widely.

 If a LEI is established to the satisfaction the Office of Financial Research by July 15, 2011, the Office of Financial Research, in consultation with the Chairperson of the FSOC, plans to issue a regulation mandating the use of such a standard for data reported to the Office of Financial Research.

 Check frequently for updates on the Dodd-Frank Act and other important securities law matters.