Legal Entity Identification for Financial Contracts

Legal Entity Identification (LEI) for Financial Contracts, a Universal Standard for Identifying All Parties to Financial Contracts is a new standard to be established by U.S. Treasury - Office of Financial Research. It is a key element in the broader effort to understand and monitor systemic risk. Its creation will likely have exceptionally broad impact throughout the financial markets at a very fundamental level.

The responsibility to building up the LEI has been given jointly to the Depository Trust & Clearing Corporation (DTCC) and SWIFT

Swift

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As stated in the development notice published in the Federal Register "The scope of the reference data provided for each LEI issued should be sufficient to verify that users have correctly identified an entity and should include at a minimum the following information for each Identifier:
"

Name
Location
Electronic address
Legal status

It is unclear if the data elements associated with each identifier will all have information that can link parents, subsidiaries and various affiliate relationships. More below.

Broad impact

Any trade on any exchange will likely involve many LEIs encoded into the detailed transaction record: buyer, buyer's broker, seller, seller's broker, exchange where traded, clearing facility, company that issued the security being traded, etc. In addition, its likely any related "infrastructure" firms involved in supporting that trade (deemed by Treasury to be potentially systemically important) will also have its LEI encoded. The concept is to pin down legal entities for every transaction, and also for every securities position (long or short) maintained.

Lifetime persistence

One goal of the LEI is to have it "persist over the life of an entity regardless of corporate actions or other business or structural changes". In the above noted requirements list that would mean the name, location, electronic address might all change several times with the LEI remaining constant. However, when the Legal entity ceased and a new legal entity assumed the operations, the LEI would change. Events such as the following are likely to cause a legal entity to change:

Reincorporation in a new State or country
Merging into another entity (one gives up its legal entity)
Bankruptcy proceeding, including reorganization
Change in structure from a partnership to a LLC, or to a corporation
In a general partnership, any change in any of the partners
In a limited partnership any change in any of the general partners
An operating division is hived off as a separate entity and partial ownership of that entity is sold to outsiders
etc.

Keeping track of relations linked through LEIs will be exceptionally challenging.

each LEI itself, needs to be kept absolutely up to date for name, address, electronic address, legal entity type changes. This alone will be a daunting task.
additional data will be needed to link parent, subsidiary and affiliate relationships (one LEI to all other links)
LEIs to all persons who own or effectively control that entity
LEIs that own various interests in other entities in various cascades including interlocking
Linking the LEI to every security ever issued by that particular LEI
Layered ownership situations such as bond trusts, etc.
Entities that are freestanding legally, but economically are virtually 100% just combinations and permutations of other legal entities, such as exchange traded funds
Derivative products (futures, options, etc.) built off large baskets of underlying securities
Mortgage pools (many-in to one-out type relationship.) Many individual mortgages, one mortgage pool. Does each underlying mortgage require its own LEI?)
Mortgage pool tranche
Tranche
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench . In the financial sense of the word, each bond is a different slice of the deal's...

(many-in to many-out type relationship.) Many individual mortgages as one collective mortgage pool, many "highly engineered" entitlements separated and issued against that single collection. The many different legal entities issued off the same underlying collection of mortgages each has vastly different legal priorities and entitlements to the underlying pool of cash flows.
Is an individual retail mortgage borrower its own Legal Entity? (Does this make sense or is it too granular?) How about any third party guarantor?
If the third party guarantor is a Legal Entity is it a simple "stand alone" entity or is it possibly partially owned or economically closely linked (directly or indirectly) to either of the two "primary" Legal Entities?
If the owners behind the Legal Entities want to operate in stealth mode, can the Legal Entities actually be intelligently linked?
Numerous additional linkage challenges, particularly over time.

One major impetus for the development of the LEI is the perceived need to assemble consolidated audit trails quickly of security transactions: who bought and who sold what, when, and who were all the intermediaries and "bottom line" owners? This can be accomplished today, however it takes a great deal of manual time and effort as the data is very widely distributed. It must be more or less manually collected and hand assembled. As of today there are formidable alignment challenges. The LEI is proposed to greatly simplify and automate that process.

Another impetus for the LEI is to more quickly and accurately determine potential domino scenarios. One single LEI fails unexpectedly, what is the domino like linkage pattern likely to be? What other LEIs are potentially effected and how might that all ripple out?

Alternatively, LEIs might be each coded for a very broad array of systemic risk exposure attributes. Then scenarios to run might be, for example, "California residential real estate plummets 30% inside a 90 day window" which LEI entities are hurt? And, most important from a systemic risk prospective, what is the LEI linked ripple effect out from there?

External links

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Broad impact

Lifetime persistence

See also

External links