Many are advocating the virtue of more transparency but may not understand the mechanics involved.
The idea of gathering information to give to regulators is simple to understand, but very complex in reality. There are no certificates, no physical documents of any kind, just electronic data identifying products, counterparties and other attributes arrayed in automated data bases. When the attributes of a financial transaction are uniquely identified as in conducting a particular trade in a product such as a stock, bond, futures, option, derivative, mutual fund, etc.; and the identities of counterparties conducting the trade are equally uniquely identified; then the transaction can be accessed by automated means, aggregated and reported on to management in performance and risk reports, and to regulators.
The problem arises first around the uniqueness of the data attributes themselves IBM for example has over 25 different identifiers used in exchange trading systems, and payment and settlement systems across the globe. Berkshire Hathaway as a business entity has at least seven different identifiers in critical information data services such as the Edgar filing system, S&Ps credit rating services, and in Markits derivatives price reporting service. Lehman Brothers had 9,076 security issues under 204 unique issuing identities, each with different numbered identities in both internal data systems and at external clearing and depository facilities. Lehman did, as many other systemically important financial firms do, operate globally making transparency a global aggregation issue for each sovereign regulator.
The second problem relates to the ubiquity of the information. If, for example, a financial institution had been doing business with Lehman across the world and they, or their regulator wanted to understand their potential loss exposure as Lehman deteriorated, they would, and did, have quite a challenge. They would have had to both discover and then collect all of the information across all the disparate internal systems and business applications storing information on Lehman, not all identifying Lehman the same way, then aggregate it, value it against closing prices, and then compare it against a credit limit that may have been extended to Lehman corporate at the top of the pyramid, or to any of its subsidiaries, or that was set to limit trading exposure to Lehman in a particular product or market. If the institution owned any of Lehmans issued securities, or derivatives; or held them on behalf of clients or in managed accounts; or had any of a multitude of relationships in which it could be doing business with Lehman; then it would have again needed to pull all of this together to further determine its, or its clients exposure.
Given the urgency of any moment when financial transactions are entered into in real time and have the potential of risk exposures far exceeding the notional value of the transaction, aggregating this information would be most meaningful if it could be brought together in near real time, but certainly daily, so that management, and regulators could make informed decisions. This does not happen in todays financial industry because the underlying identifying data and valuation information are sourced independently, with each financial institution performing duplicative functions in an attempt to represent each unique product, business entity and valuation price identically, but failing to do so. The consequence is that proprietary and conflicting valuation prices and identification codes exist across the entire range of identifying data, including such fundamental identifiers as symbols for corporate issuers, symbols used in contract markets, numbering conventions for securities, supply chain business entity identifiers, and counterparty identifiers. This causes built-in delays in mapping and reconciling data. In the U.S. securities markets it takes three days for this process to run its course, with significant risk and cost consequences in the interim, notwithstanding the difficulty in getting accurate data to regulators in any meaningful time frame.
Standardizing data has long been desired so that industry participants can converse in a seamless, error free and electronic manner with both its counterparties and its regulators in the industrys long sought after Straight-Through-Processing (STP) vision. Although the benefit of open and uniform standards is well researched and advocated by many, it still remains a distant vision because of short-term cost considerations and the expected selfinterests of those vendors, servicing organizations and financial enterprises that have evolved their businesses around proprietary codes and non-standard conventions. These actions evolved over many decades and have placed a high hurdle on financial firms in switching costs to move to open and uniform standards.
What regulators and the industry need to do now is focus on spending some of the infrastructure funds earmarked for the industrial infrastructure of our country for the infrastructure of our information-based financial sector. Discovering and reporting on the buildup of global risk exposure in our financial institutions is critical, having come to appreciate this from the current financial crisis and the new context of systemic risk that it uncovered.
We should all be able to relate to the benefit of regulatory support for societal benefit in a similar instance when switching costs where proving insurmountable and the U.S. Federal Communication Commission stepped in to mandate a policy change on cell phone number assignments. Prior to mandating a single, universal and portable number for an individual or business entity, each provider of network services had assigned unique numbers to their own clients. Switching costs, both in monetary terms and measured in terms of the risk of losing calls and contacts, was a high hurdle to overcome. Even though services were poor or deteriorating people were reluctant to switch because it meant losing their assigned number. Similar regulatory intervention would be essential to standardize and centralize product and business identity numbering conventions and valuation prices. It would go a long way in making transparency a reality in our financial sector.
This article originally appeared on Securities Industry News.
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