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In the first book of the Old Testament, God punishes the builders of the Tower of Babel for their folly. The choice of punishment is revealing… The costs of that original sin are still being felt.
Who but Andy Haldane, Executive Director for Financial Stability at the Bank of England, would begin an essay about the normally enervating topic of finance data-tagging with such a paragraph? Of course, if anyone is up to the task of convincingly assigning Biblical importance to back office processes, it’s probably him.
It might be because what Haldane suggests in his latest paper, which proposes a “common language” for all financial data, has the potential to go Biblical on many a bank’s business model. On financial intermediation itself, maybe.
Haldane starts with a discussion of the economic benefits of common languages in various contexts.
Bilateral trade tends to be higher between nations of a common tongue. The introduction of barcodes and scanning proved miraculous for the efficiency and lengthening of supply chains; previously items were labeled in bespoke languages of the countries where they were produced. And the development of hyper-text markup language (HTML) allowed computers to “communicate irrespective of their operating systems and underlying technologies”.
In the latter two cases, supply chains and the Web, the new common languages were obviously made possible by new technologies — and as these technologies have grown more sophisticated through the decades, they’ve been complemented by a non-profit overseer: the GSI keeps tabs on the 40 million products, and the World Wide Web Consortium (W3C) monitors web standards. At the same time, being able to use the “common languages” early, and adeptly, led to massive profits. Think Walmart and Google. There’s an interesting pro-competition vibe to this form of regulation that we’ll pick out more in a sec…
Anyway, Haldane’s argument is that technology can do something similar for finance, whose delay in introducing a common language has lagged product supply chains and the web by a generation, and along the way made sorting out who owes whom what in a financial crisis very hard to accomplish. Here are a few extracts from the paper:
Most financial firms have competing in-house languages, with information systems silo-ed by business line. Across firms, it is even less likely that information systems have a common mother tongue.Today, the number of global financial languages very likely exceeds the number of global spoken languages.
The economic costs of this linguistic diversity were brutally exposed by the financial crisis. Very few firms, possibly none, had the information systems necessary to aggregate quickly information on exposures and risks.
This hindered effective consolidated risk management. For some of the world's biggest banks that proved terminal, as unforeseen risks swamped undermanned risk systems.
These problems were even more acute across firms. Many banks lacked adequate information on the risk of their counterparties, much less their counterparties' counterparties. The whole credit chain was immersed in fog. These information failures contributed importantly to failures in, and seizures of, many of the world's core financial markets, including the interbank money and securitisation markets. …
At the same time, there is a distance to travel before banking harvests the benefits other industries havealready reaped. A common financial language has the potential to transform risk management at both the individual-firm and system-wide level.
It has the potential to break-down barriers to market entry, leading to a more decentralised, contestable financial sector. And it thereby has the potential to both boost financial sector productivity and tackle the too-big-to-fail problem at source. There is no technological barrier to this transformation.
And private and social interests are closely aligned as improved information systems are a public as well as a private good. That public-private partnership isone reason why such good progress has been made over the past few years. So stand back for a good news story "“ a story of how finance could transform both itself and its contribution to wider society.
———
As it happens, something resembling a move towards a common financial language was begun more than two years ago under the auspices of the G20. The Financial Stability Board began reporting to the finance ministers of these countries and promoting the use of Legal Entity Identifiers (LEIs) and Product Identifiers (PIs).
We recommend the whole paper if you want to understand these concepts in more depth, but the easiest way to think about them is in this passage: “LEIs are effectively the nouns of a new financial vocabulary, naming the counterparties to each financial transaction. Meanwhile, PIs are the adjectives of this new vocabulary, describing the elements of each financial transaction. Together, LEI-nouns and PI-adjectives are key building blocks of a new common financial language.”
Another long excerpt on progress to date (and where Haldane’s enthusiasm for these tools is evident) but feel free to skip if you’d like to go straight to our concluding thoughts:
International efforts so far have focussed on global LEIs. These are means of capturing, in a common data string, the old banking maxim of "know your counterparty". In today's financially interconnected world, knowing your counterparty may be insufficient. So global LEIs aim to barcode counterparty linkages at any order of dimensionality.
In November 2010, the OFR issued a policy statement on LEIs. This kicked-off an industry process, led by the Securities Industry and Financial Markets Association (SIFMA), aimed at settling on a single,industry-wide entity identification standard. This industry process formally began in January 2011, issued its requirements document in May 2011 and recommended a consortium led by the Depository Trust and Clearing Corporation (DTCC) as its preferred provider in July 2011.
DTCC is currently running a private sector entity identification pilot project, starting with over the counter derivatives. Although this market is fairly concentrated, building the database still poses challenges. DTCC anticipates the database could contain over 1 million entities. This pilot will provide valuable experience when moving to a broader range of products and market participants.
The FSB is constructing an LEI roadmap, harnessing the efforts of both official and private sectors. Itsdestination is a single, global LEI standard. As announced last week, significant progress is being madeacross five fronts: governance, operational model, scope and access, funding and implementation and phasing. The FSB will present its LEI recommendations to the next G20 summit in June 2012.
Creating a PI for finance is altogether more complex. Finance is in the pre-barcode era for retail products or the pre-web era of the internet. But enough work has already been done to demonstrate that PIs are feasible. As long ago as 1997, the International Organization for Standardization (ISO) released a standard for the Classification of Financial Instruments (ISO 10962) and designated the Association of National Numbering Agencies (ANNA) as the registration body for this standard.
More recently, following G20 commitments, the industry has been working to standardise classification of OTC derivative products. …
As yet, we are some distance from having a consistent global method for financial product identification. The prize beyond that, a big one, would be to integrate LEIs and PIs using a commonly-agreed global syntax – an HTML for finance. This would allow us to move from words to sentences. It would provide an agreed linguistic base for a common financial language. Provided this language is flexible enough, like GS1 standards or HTML, it ought to be capable of describing any instrument whatever their underlying complexity. Once developed, maintaining and updating this common language and syntax is likely to need some global governance body to act as guardian.
More to come this June when the FSB presents its LEI recommendations at the next G20 meeting. We know, that’s a mouthful of acronyms.
———
Haldane’s case is persuasive but it’s early days yet, and a number of unanswered questions remain.
If everything ultimately gets tagged, how visible should the linkages be? Should they be accessible by the public, or only by the firms and regulators? How hard will financial institutions fight this effort? They’ll be suspicious of it, we suspect, having profited handsomely from information asymmetries and matching borrowers with investors.
But then again, banks haven’t been very good at exploiting those asymmetries lately. Take a look at at a typical investment bank’s Q4 2011 revenues, for instance. Or have a glance at performance in 2006 compared against 2011, as compiled by William Wright recently:
My analysis comparing the performance of large investment banks in 2011 with the happier days of 2006 shows that the financial crisis has knocked the stuffing out of the industry. Overall revenues are down by 17%, pre-tax profits have collapsed by 52%, and pre-tax ROE across the street has plunged from a heady 37% to a miserable 10%.
And as Haldane writes in his paper — “birth rates” in banking are very, very low. No de novo lenders were created in the United States in 2011, the first fallow year in decades, as the FT’s Tracy Alloway recently reported.
That might be the kind of market waiting for a Walmart or a Google…
There are other questions too, even if this isn’t an existential challenge to banking business models.
Will regulators force financial institutions to comply? If so, it will call for at least a partial retooling of banks’ back-offices and new hires (remember that the introduction of barcodes and scanners naturally required new employees to scan the barcodes).
How would this either be independent of or complementary to other proposed or expected regulations? For swaps and SEFs? For the shadow banking system? For repo markets? If we’ve understood this correctly, a system of LEIs and PIs isn’t focused on preventing another Lehman. It’s meant to prevent another aftermath of Lehman — in which the opacity of counterparties and trades created havoc in lending markets and, post-bankruptcy, required three years to untangle most of the mess.
Maybe the paper should be read in that context, keeping also in mind the many other murky corners of finance that remain, as our colleague Gillian Tett explained last week.
It’s too early to know what will become of LEIs and PIs, but surely the costs of multiple languages are too steep and too obvious to continue ignoring.
By Cardiff Garcia and Joseph Cotterill
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© The financial Times Ltd 2012 FT and 'Financial Times' are trademarks of The Financial Times Ltd.
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