It’s three years after the financial crisis, and we still don’t have the most basic data that we need in order to be able to spot a gathering storm in the financial markets.
Especially needed is more information about shadow banking* transactions, particularly repurchase agreements, securities lending, derivatives and securitization. These were the interconnected markets that seized in 2008.
At that time, neither bankers nor regulators could tell what was happening or how to respond. There was little data and even less analysis.
Since then, not much has changed.
“It was the collapse in funding markets which made the crisis global, and yet we cannot really see funding patterns in the available data,” said Hervé Hannoun, Deputy General Manager of the Bank for International Settlements, as he called for better data collection back in April 2010.
From a Bank for International Settlements conference about information gaps August 25-26, 2011:
A key feature of the crisis was the high dependence on short-term finance to purchase long-term assets, leading to a mismatch between the maturity structure of the corporations’ assets and liabilities. Such maturity transformation exposes financial institutions and entire markets to vulnerabilities of market runs. However, owing to a lack of data, regulators, supervisors and market participants could not fully measure the degree of maturity transformation or the extent to which financial institutions and markets were interconnected.
To people in the data tracking business, this is nuts.
Bernie Hogan, chief technology officer of the U.S. operations of GS1, the official provider of bar codes worldwide, told Securities Technology Monitor in May:
I can’t imagine that something as valuable as securities doesn’t have this. The more I understood, I was kind of shocked.
The Dodd-Frank Act created the Office of Financial Research to fill this void: To collect and analyze information that regulators and bankers need to help them prevent another systemic crisis.
(Editor’s Note: See accompanying story about the information that needs to be collected on repurchase agreements and securities lending, according to economists at the Federal Reserve Bank of New York.)
The intention of the Office of Financial Research is to assign numbers to every participant and every type of transaction and to create databases with the information. Then regulators, bankers and to some extent the public can query the databases, analyze the results, and assemble reports.
The numbers for participants are being called Legal Entity Identifiers, or LEIs. That’s the first jargon you need to know to navigate this area of financial reform.
So, how’re we doing?
The Office of Financial Research is still plodding through rounds of studies and meetings with industry representatives and other regulators, seeking international consensus on a way to assign numbers to financial market participants. It hasn’t begun working on numbers for transactions. (See chronology of efforts below.)
To make matters worse, it’s working only on a system to track derivatives called swaps, like credit default swaps. It’s not planning to track other derivatives, repurchase agreements, securities lending, or securitization transactions because Dodd-Frank doesn’t require it.
That’s a serious omission, said Alistair Milne, professor at Loughborough University School of Economics and Business and author of RepoWatch’s favorite book about the financial crisis, “The Fall of the House of Credit.”
In a November 1 speech that he called “If you want to stop a flood, then fix the piping,” Milne said:
The gap in this work is that as yet it has not been extended to cover all financial contracts, for example the entire gamut of so called ‘shadow banking.’
As already indicated, data standardization – if it is to provide regulators, firms and investors with all the information they need to avert systemic problems and ensure appropriate disciplines on financial firms – must be universally applied to all financial contracts.
The most glaring gap at the moment is in relation to collateralised and uncollateralised short-term money market contracts, for example the repo and ABCP instruments whose breakdown was at the heart of the crisis of 2007-2008.
For sure, standardizing reports on financial transactions is a formidable task, and to be useful it needs to be international.
From freelance business and technology journalist Katherine Heires, in a story called “Time to Feed The Beast” that analyzed the complexities of data management (the story appeared in the June 2011 Risk Professional magazine, published by the Global Association of Risk Professionals):
“..a large financial institution may work regularly with 500,000 to 800,000 business entities, and identifying and verifying all those database entries is no small task.”
The problem is that every firm, indeed virtually every division and trading desk, has developed piecemeal approaches to the recording of financial information. Regulators can indeed ask for data dumps, for multi-Gigabyte files that contain all exposures. But even when regulators have the requested information they can do nothing with it. Information without uniform data standards is simply not accessible.
In addition to hurdles posed by the complexity of the task, the effort is running into some opposition.
The Financial Services Rountable, a lobbying group for financial institutions, sounded a bit exasperated in a report published September 10, 2010, when it urged the Office of Financial Research to first make thorough use of the “extensive information that is provided already to regulators on a regular basis.”
The Office of Financial Research is trying to do too much too fast, Stephen C. Daffron told Securities Technology Monitor reporter Tom Steinert-Threlkeld for a May 3, 2011, report. Daffron is global head of operations and technology at Morgan Stanley & Co.
He said he had recently been in Washington, D.C. to meet with the Commodity Futures Trading Commission, the Securities and Exchange Commission, the Federal Reserve Board, the Federal Deposit Insurance Corporation and “a partridge in a pear tree.”
His resulting impression? That huge amounts of data will be collected, in ways that are likely to be inconsistent and not easily analyzed. And that the rush to collect data this year and next will impede the analysis of it. …
“I don’t see the OFR being anything like the surgical instrument that the legislation envisioned,” he said. “Simply because there’s too much (data being collected). It’s too complicated. Maybe at some point we can structure it in a way that is more precise. But right now I don’t see it.”
Some Republicans in Congress think the Office is intrusive and not needed and would like to abolish it. Wall Street Journal reporter Victoria McGrane reported on the opposition in the Real Time Economists blog July 14, 2011:
The subject of an oversight hearing Thursday, the investigating subcommittee’s chairman, Rep. Randy Neugebauer (R., Tex.) criticized the office’s data-collecting mission as “Orwellian” in his prepared remarks, and painted an image of powerful bureaucracy with no limits on how much it can spend or what information it can demand from the industry, a characterization echoed by many of his Republican colleagues.
Author and investor Nassim Taleb, one of the witnesses at the hearing, described the office in his prepared testimony as an attempt to create “an omniscient Soviet-style central risk manager.”
McGrane said Taleb’s point was that trying to measure financial risk to predict the next crisis could actually increase risk, because it might make people overconfident in the information, which Taleb believes will inevitably be flawed.
McGrane said other lawmakers called the Office of Financial Research “a hacker’s dream.”
In part because of the opposition, President Obama didn’t nominate someone to head the Office until December 16, 2011, wrote reporter William Alden for The New York Times’ January 3, 2012, DealBook column. Not until December did the Office move from cramped temporary quarters into a larger space. From Alden:
Establishing the Office of Financial Research has become another example of the struggle to put the Dodd-Frank regulatory overhaul into effect.
The agency, which is tasked with collecting and analyzing reams of bank data on behalf of the Financial Stability Oversight Council, has been slow to fill its ranks and has missed deadlines….
Although Mr. (Richard) Berner has been tapped for the top post, it could take months for the Senate to approve him — if it does at all.
Currently, the Office of Financial Research is six months late but claims to be progressing in its efforts to establish a Legal Entity Identifier program, and it is working with the Commodity Futures Trading Commission and the Securities and Exchange Commission as they set up systems for tracking swaps.
Meanwhile, a consortium of key industry associations said it supports the development of Leading Entity Indicators and released its proposals July 11, 2011, for the standard it prefers and the companies it would like to see do the work. The paper distinguished the consortium as making the most concrete progress of any group.
The consortium said it supports the ISO 17442 standard and the following companies to run the LEI program: The Depository Trust & Clearing Corporation (DTCC), the Society for Worldwide Interbank Financial Telecommunication (SWIFT), DTCC’s subsidiary Avox, and the Association of National Numbering Agencies.
Internationally the Financial Stability Board, which was set up in 2009 to promote stability in the international financial system, said it will report to the G-20 Summit in Mexico in June 2012 on how it believes the LEI effort should be administered and overseen (“governed”).
Although these efforts fall far short of implementation, they do represent progress and that’s good, said Milne.
Unheralded, almost unnoticed, recent months have seen progress on what may yet turn out to be the single most significant reform of the financial system post crisis: the one that does more than any other to ensure that we never again have a chaotic market breakdown of the kind that took place in the autumn of 2008.
Reforms initiated since the financial crisis cannot be effective without this type of information, Milne said. For example:
This reform is critical to the agenda of having plans for the orderly resolution of investment firms. The major task in orderly resolution is establishing who owes what to whom. With adequate recording of contracts this too can be done virtually instantaneously.
It is also critical to virtually all the other planks of regulatory reform. Without universal registration of positions in a form accessible to regulators, the macro-prudential function cannot operate effectively. Capital and liquidity requirements and other measures such as the Volcker rule can be evaded.
In his November 1 speech, Milne urged regulators to persevere in the face of opposition, saying firms have strong incentives to resist more data collection, “to keep prying eyes away from what they do,” but the data collection effort is critical.
Regulators simply need to be able to say that any contract, for which the necessary data standards and reporting systems have not reached the standard required by regulators, allowing firm management and outsiders appropriate access to information, shall be treated like a gambling contract: not enforceable in law.
Milne said he worries that the work won’t get done in time.
Full development and implementation will take some time and the next global financial crisis could well be upon us before this essential task is complete.
A chronology: Progress in slow motion
-In April, the Group of Twenty (G-20) called on the International Monetary Fund (IMF) and the Financial Stability Board (FSB) to study the financial crisis and information gaps. The two agencies issued a report October 29, calling for beefed-up collection of information on: International data, systemwide measures of leverage and maturity mismatches, credit default swaps, interconnectedness of giant global financial institutions, and nonbank financial institutions.
The recent crisis has reaffirmed an old lesson — good data and good analysis are the lifeblood of effective surveillance and policy responses at both the national and international levels.
-President Obama signed into law on July 21 the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created the Office of Financial Research, saying:
Now, beyond the consumer protections I’ve outlined, reform will also rein in the abuse and excess that nearly brought down our financial system. It will finally bring transparency to the kinds of complex and risky transactions that helped trigger the financial crisis.
-On November 30 the Office of Financial Research announced plans to develop an LEI-type program:
In establishing such rules the Office would prefer to adopt a universal standard developed and implemented by the financial industry and other relevant stakeholders through a consensus process.
-On March 31 the International Organization for Standardization (ISO) began work on a new ISO standard “ISO 17442” which will set out the standards LEIs must meet in order to be acceptable to both industry and the public sector.
-On May 3, 12 trade associations under the leadership of The Securities Industry and Financial Markets Association published their “Requirements for a Global Legal Entity Identifier (LEI) Solution.“
The Trade Associations have fully embraced the need for an LEI solution to be established and implemented by private industry and other relevant stakeholders through a consensus process. We are committed to working with regulators and supervisors globally to develop this essential LEI Solution as a key foundational tool to help promote industry and supervisory efforts to enhance financial stability.
-It’s time, said Tim Rice, the global head of pricing and reference data at Thomson Reuters, in the Securities Technology Monitor’s Idea Exchange May 12.
Every financial crisis from the meltdown of Long Term Credit Management to the subprime mortgage debacle and the collapse of Lehman Brothers has triggered renewed calls for better legal entity data.
-“Adoption of Legal Entity Identifiers Will Come … Slowly,” wrote the Securities Technology Monitor in a June 14 update by reporter Chris Kentouris.
OFR will find it “will not be an overnight Big Bang approach or even a year-long approach,” in gaining adoption of identifiers, according to Lucille Mayer, managing director for technology at Pershing, the Jersey City- headquartered clearing arm of Bank of New York Mellon. “Financial reporting and regulatory reporting systems will need time to incorporate the new code as will trading, custody and clearing systems, to name a few.”
-On July 11, the 12 trade associations that published “Requirements for a Global Legal Entity Identifier (LEI) Solution” released a report supporting the ISO 17442 standard and calling for the following companies to build, manage and run the LEI program: The Depository Trust & Clearing Corporation (DTCC), the Society for Worldwide Interbank Financial Telecommunication (SWIFT), DTCC’s subsidiary Avox, and the Association of National Numbering Agencies.
Given the robust process it has undertaken, the Coalition feels it is putting forth the group of organizations that has the best opportunity to implement the LEI operational system.
-Tom Price, Managing Director of Operations and Technology with the Securities Industry and Financial Markets Association (SIFMA), said in the Voices section of Securities Technology Monitor September 22 that the July 11 recommendations represented the work of a global industry group with 251 members from 73 different firms and associations.
We have made tremendous progress in a very short amount of time – in my many years working in the industry, I can say with confidence that this effort has been second to none in its global outreach. We are committed to working with regulators and supervisors globally to develop this essential new LEI tool to help measure and monitor systemic risk and counterparty risk, as well as help institutions achieve operational efficiencies.
-The Office of Financial Research said August 12 it’s seeking more international buy-in before it will issue a rule requiring that LEIs be used for reporting data to the Office.
In November 2010, the OFR stated that if a universal LEI was established by July 15, 2011, it planned to issue a notice of proposed rulemaking that would require the LEI to be used for data reported to the OFR. Although significant progress has been made to date in developing an LEI—including discussions of principles by global regulators; recommendations by a global coalition of financial services firms and trade associations; a technical specification for the identifier by an international standards body; and proposals by parties to manage the LEI—additional work needs to be done to build international consensus on key issues before the OFR issues a rule.
-At the close of the G-20 summit in Cannes, France, November 4, officials released a statement urging that the Financial Stability Board take the lead in coordinating efforts worldwide to bring a recommendation on how the LEI effort should be administered and overseen (“governed”) to the next G-20 summit in Los Cabos, Baja California Sur, Mexico, June 18-19, 2012:
We support the creation of a global legal entity identifier (LEI) which uniquely identifies parties to financial transactions. We call on the FSB to take the lead in helping coordinate work among the regulatory community to prepare recommendations for the appropriate governance framework, representing the public interest, for such a global LEI by our next Summit.
-On December 16 President Obama nominated Richard Berner to head the Office of Financial Research. Berner, a former chief U.S. economist for Morgan Stanley, has been leading OFR since he became a counselor to Treasury Secretary Timothy Geither on April 25, 2011, with the task of building the research office.
-On December 20 the Commodity Futures Trading Commission adopted its rules for swaps reporting, which is thought to make CFTC the first regulator to mandate the use of LEIs. It called for the use of three unique identifiers: a Unique Swap Identifier (USI), a Legal Entity Identifier (LEI), and a Unique Product Identifier (UPI).
-The U.S. Treasury Department said December 29 that on July 20, 2012, it will begin collecting fees from bank holding companies and foreign banking organizations with at least $50 billion in assets, and from nonbank financial companies supervised by the Fed, to finance the operations of the Office of Financial Research and other crisis-era programs, as authorized by the Dodd-Frank Act.
–On January 12 the Financial Stability Board said it is forming a private-sector group of experts to advise a new LEI Expert Group of global regulators. By April the LEI Expert Group is supposed to come up with how the LEI effort should be administered and overseen (“governed”). The group will then submit its ideas to the G-20 Summit in June.
*Shadow banking is where deposits and loans are made outside the traditional banking system. Much of the borrowing in shadow banking is done on the repurchase market, and in the lead-up to the financial crisis of 2007-2008 banks used much of that money to make home loans and securitize them.
Shadow bankers include money market funds, securities broker-dealers, investment and commercial banks and their holding companies, securities lenders, finance companies, mortgage brokers, foundations, issuers of asset-backed securities (ABS) and asset-backed commercial paper (ABCPaper), derivative users, hedge funds, and off-the-books businesses variously known as trusts, special purpose entities, special purpose vehicles, variable interest entities, conduits, or structured investment vehicles.
Good post, but is your point that national or global regulators should have an entire data set on all banking transactions globally? And if so – do you realistically think this will provide any useful insights? The amount of data is enormous, the speed with which it changes it also high, and the ease with which regulators could find any pattern or deep insight into such a complex inter-connected system, is very low. Maybe I’m not arguing against collecting the data, but then again, the cost and complexity is so high, and the usefulness of the output so low, I wouldn’t want to present a business case to build it. Best wishes, Bill.
Reblogged this on The OTC Space and commented:
Interesting commentary on data collection across the markets. Even if we had all this data across all the markets, could regulators achieve anything meaningful from it? I doubt it.
That’s a good point. Am I putting too much faith in the ability of technology? I guess I’m thinking that if we can sequence DNA and make sense of it, and if we can track credit default swaps, we can write programs to do the same with the repo market.
Isn’t this the kind of information that large financial institutions should be collecting for their own internal analysis anyway? Couldn’t they adopt a standard format and sort the data into a report OFR can use?
But beyond all this, I don’t understand tracking credit default swaps and not tracking repos. Do you?
I wrote three pieces in 2008 on the wider idea of using all the data collected to build the “mother of all simulations” to try to spot systemic risks, the pieces can be downloaded in PDF from here http://theotcspace.com/writing/ – scroll down to 2008.
Most of the CDS data is held at the DTCC Trade Information Warehouse already, and much of the Repo data is held within the DTCC Repo service, or within the LCH RepoClear service.
The biggest challenge is using such a large data set to make meaningful results, simulating the capital markets is non-trivial, as once you start looking at the input factors you end up having to simulate the behaviour of people – not easy.
All interesting thoughts though – and it’s not just Repo – to complete the set you’d need to cover the entire market including Bonds, Equities, Repos, Stock Loan, Futures, Commercial Lending, OTCs etc,
I can’t answer your final question – why does the DFA only focus on the OTC products, which by definition include Repo and Stock Loan? It’s a puzzle.
Bill, thank you for the years of thought and hard work you have put into these issues.