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Legal Entity Identifiers (LEIs): an essential tool for regulators and an opportunity for firms

Matt Smith is CEO of SteelEye, the compliance tech and data analytics firm 

Matt Smith, CEO of SteelEye

Matt Smith, CEO of SteelEye

Over the past months, there has been a surge in the number of financial firms obtaining a Legal Entity Identifier (LEI) – an alpha-numeric code of 20 digits that enables each legal entity participating in financial transactions to be uniquely identified. This rush has been precipitated largely by growing regulatory requirements. Most notably,the Markets in Financial Instruments Directive II (MiFID II), which comes into force on 3 January 2018,significantly expands the requirements governing who must be registered under an LEI.

The broader reach of MiFID II’s regulations will help national financial authorities to expose and ameliorate systemic risks in the marketplace before they become unmanageable.Therefore, more and more firms will find themselves under a regulatory regime which mandates the use of LEIs either immediately or in the coming years.Irrespective of the regulatory need, there are also compelling business reasons for any firm that can obtain an LEI to do so as soon as possible – including a potentially substantial reduction in operations costs.

In the analysis below, Matt Smith, CEO of SteelEye,the compliance tech and data analytics firm, examines how the LEI system is set to become a pervasive feature of the financial services landscape – and the benefits financial institutions can expect if they embrace it.

MiFID II and beyond: the LEI as a permanent feature of the financial regulatory landscape

According to the Global Legal Entity Identifier Foundation (GLEIF), the number of legal entities worldwide with an LEI surged from 520,000 at the end of June 2017 to 740,000 today – an increase of more than a third in less than half a year with expectations of continued growth.

One reason that this increase in numbers has been especially pronounced in recent months is the scramble by financial institutions to comply with MiFID II before its deadline in January. MiFID II will be one of the most wide-reaching regulatory measures imposed upon the financial services industry since the global financial crisis. Amongst its requirements is an overhaul of transaction reporting: the process by which firms are required to send their trade data at regular intervals to an Approved Reporting Mechanism. Any firm subject to MiFID II transaction reporting obligations will need to ensure that its clients have an LEI if they are eligible for one, or else will be prohibited from executing a trade on their behalf.

This continues a regulatory trend that began more than half a decade ago. The LEI system was developed by the Group of Twenty forum of governments and central banks, to be a global standard which is freely accessible to everyone through an open, searchable database. The idea is not a new one, but prior efforts to create standardised legal identification systems were too fragmented. It took the financial crisis to drive coordination on a global level.

The first LEIs were issued in 2012. They have since been – and continue to be – incorporated into regulation in jurisdictions around the world. The sweeping Dodd-Frank regime in the US was an early adopter of LEIs, mandating their use for every market participant that transacts over-the-counter (OTC) derivatives. To date, the European Securities and Market Authority (ESMA) lists 11 EU regulations or directives which require the use of an LEI for specified legal entities. MiFID II is just the latest of these.

Authorities have identified LEIs as an essential tool to avoid the type of paralysing uncertainty which abounded after the financial crash – most conspicuously following the collapse of Lehmann Brothers, the fourth largest US investment bank, in September 2008. At that time, Lehmann’s vast labyrinth of legal entities had no standard global identification system for each financial counterparty. This made the task of identifying counterparties’ exposure to each of Lehmann’s entities, and to each other, so complicated as to be practically impossible.

Under the current system, that labyrinth is often exacerbated by the fact that most legal entities have multiple identifiers that are used for different purposes – from various tax identification numbers to payments IDs. The outcome can be a system so complicated and convoluted that is dangerously impenetrable, even to regulators.

LEIs bring much-needed clarity to this process. Put simply, each identifier is designed to answer three fundamental questions: ‘who is who?’, ‘who own whom’, and ‘who owns what’. The first question, for example, can be answered with ‘business-card data’: official names and registered addresses. The data pool is being gradually enhanced to contain data about ownership and parent-subsidiary relationships.

LEIs are available to ‘legal entities’, defined by the European Payments Council as,“unique parties that are legally or financially responsible for the performance of financial transactions or have the legal right in their jurisdiction to enter independently into legal contracts”. These parties might be incorporated, for example, as a trust or a partnership. A legal entity can also be an individual acting in a business capacity, as well as a governmental or supranational organisation. Once a legal entity obtains an LEI, it retains the code for life. An annual verification process ensures data is kept trustworthy and up to date– and anyone can see when the information related to a specific LEI was last verified.

Just as with Lehmann Brothers, it is widely acknowledged that the inability of financial institutions to track their counterparties as legal entities, and monitor their activities, was an important contributory factor to the financial crisis.Regulators in every jurisdiction agree that to effectively hunt for systemic risk across incredibly complicated and interconnected global financial systems, they need a standard which identifies any particular financial market participant to each regulator in the same way.

It is clear that this global standard is the LEI. As of September 2017, the GLEIF lists 110 current and proposed regulatory activities which include the use of LEIs in 14 different jurisdictions. It is inevitable that this number will expand over the coming years, and that more and more entities will fall under the purview of these regimes.

More than compliance: the business case for LEIs

While the requirement to obtain an LEI stems from financial regulators, any legal entity that enters into a financial transaction is eligible for an LEI. But why should firms that do not yet fall under such a regime bother to get one voluntarily?

A convincing answer lies in the strong business case for firms to embrace LEIs. From the perspective of individual firms, the nebulous maze of legal entities borne out of multiple identifiers under the pre-LEI system creates significant costs. Entry identification consumes considerable time and resources which could be better spent elsewhere, and creates inefficiencies by replicating efforts across the industry. This is especially problematic when it comes to tracing very fragmented cross-border structures. The resulting information can be contradictory, and even ineffective for identification purposes.

The business value of the LEI system lies in its ability to first, reduce the time and resources spent on identifying counterparties, and second,to improve the reliability and depth of the ensuing information.Using LEIs can help improve communication both within individual firms interacting between their various business departments, and between different organisations altogether.

A recent study by McKinsey and the GLEIF found that the potential cost savings to the industry are substantial and measurable. It concluded that it is possible to create savings of at least 10 percent of total operations costs for client onboarding and trade processing for banks adopting the LEI. This would, for the broader investment banking industry alone, create annual savings of over $150 million. Meanwhile, in trade finance, banks could save an additional $500 million perannum by using the LEI in the issuance of letters of credit.

The study examined a number of plausible applications for LEIs beyond their current use. For example, in capital markets, the first firms to widely adopt LEIs have been entities involved in OTC derivatives trading. Here, LEIs have also been used for purposes such as fulfilling Know Your Customer (KYC) requirements and documentation. For instance, they can help to immediately identify documents showing whether a client can enter into a certain type of trade when time is of the essence.

Among the many other potential applications for LEIs in the financial services industry are commercial transactions – especially when it comes to invoicing and trade finance; and the extension of commercial credit – where the need to identify the borrowing entity’s identity, history, and ownership structure can be greatly facilitated and expedited. More generally, many other back office processes that require manual verification of counterparties are in line for dramatic improvement via broader use of LEIs.

A win-win for regulators and institutions

All in all, the spread of the LEI system is an essential step for the global financial services industry. It equips regulators with a tool that helps tackle a serious cause of the financial crisis – a lack of transparency around the innumerable interconnected entities that make up the global financial system. Meanwhile, it empowers firms to cut costs, simplify their operations, and gain a much deeper insight into their counterparties. The impact – in compliance, risk management, client relationships, and a host of other areas – should be profound.

Firms can register their LEI by selecting from a variety of preferred business partners, called LEI issuers. Legal entities are not restricted to using an LEI in their own country, but can choose from any accredited and qualified issuer within their authorised jurisdiction.The cost of obtaining an LEI varies by issuer, including an initial registration fee and an annual maintenance fee.

Our recommendation is for every eligible entity – that is, any legal entity that enters into a financial transaction – to obtain an LEI, even if they are not yet obligated to do so by their regulator. The LEI system is a win-win for regulators and institutions. Participating within this system is a necessary step to bring firms into a more transparent world which has learned from the mistakes of the past – and creates tangibles business benefits and opportunities in the process.

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