By Terry Flanagan

Dark Knight: What’s In Store for Risk Managers?

While the Knight situation and other highly-publicized instances of failures in market mechanics are stirring up memories of the 2008 financial collapse, the subject of identifying and controlling systemic risk are being once more dissected by the marketplace.

In the case of OTC derivatives, which were at the center of the 2008 crisis, regulators have proposed a system of legal entity identifiers (LEIs), a global program designed to create and assign unique identifiers to every financial organization that engages in a financial transaction.

Regulators will use LEIs to better gauge systemic risk, and risk managers at financial institutions will use LEIs to better understand and aggregate counterparty exposures and risk.

“With all the discussions about the LEI we shouldn’t lose sight on the real objective,” said Tim Lind, head of legal entity and corporate actions at Thomson Reuters. “Development of an LEI system is not the goal. Likewise, the disclosure of swap positions per se doesn’t create any additional transparency or stability. These are just building blocks.”

The real goal, said Lind, “is the development of new risk management models and analytics that can help detect an episode of market risk and are capable of remedial actions before they result in systemic risk. The longer it takes to establish these building blocks, the longer it will take to realize the actual value of this initiative, which is to develop better insight into the behavior of markets and create effective and prudential risk management policies,” said Lind.

Banks need to start planning now for the anticipated changes being wrought by OTC reforms, said David Dixon, product manager of Summit at Misys.

“The main issue is timelines,” said Dixon. “At some point, banks will need to start implementing systems for LEIs even as the final regulatory framework is yet to be completed.”

The CFTC has nominated Depositary Trust & Clearing Corp. (DTCC) to assign and publish CFTC Interim Counterparty Identifiers” (known as CICIs) to uniquely identify parties to an OTC derivative position when disclosing information to the CFTC.

“It is called an interim identifier until the LEI system is set up and operational,” said Lind. “After that point official LEIs will replace the CICI in disclosers to the CFTC. Both identifiers are based on an ISO standard so we expect the actually numbers to stay the same.”

The first phase of the LEI system is targeted for March 2013 and the first swap transactions using CICI will begin in October of this year.

“The nomination of DTCC was consistent with our expectations and are the best positioned to meet the timeline and requirements for compliance with CFTC disclosure rules,” Lind added.

The FSB recommends a federated three-tier structure for the global LEI system: a regulatory oversight committee (ROC), a central operating unit (COU) and a local operating unit (LOU).

The ROC will have the ultimate responsibility for governance of the LEI system, while the COU is the pivotal operational arm of the global LEI system, with responsibility for ensuring the quality of the LEI and proving open access to the LEI and to high-quality reference data. LOUs will provide the primary interface for entities wishing to register for LEI. As such, they will be the local implementers of the LEI system.

“The federated model is designed to promote maximum inclusion of local players in the LEI system,” said Lind. “While this may increase the likelihood of global adoption it also introduces a lot of complexity in the system – specifically in the interactions between the COU and the various LOUs.”

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