The recently published FSB report entitled ‘A Global Legal Entity Identifier (LEI) for Financial Markets’ started with an introduction:
“There is widespread agreement among the public authorities and financial industry participants on the merits of establishing a uniform global system for legal entity identification. … But despite numerous past attempts, the financial industry has not been successful in establishing a common global entity identifier. The finance sector consequently lags well behind many other industries in agreeing and introducing a consistent global framework for entity identification.”
Why has the finance sector not been successful in introducing such a global framework, given the clear and obvious benefits?
The answer can be found in the economic theory of public goods. The concept of public goods was introduced by Paul Samuelson in his classic 1954 paper The Pure Theory of Public Expenditure. He defined public goods (collective consumption goods) as:
“[goods] which all enjoy in common in the sense that each individual’s consumption of such a good leads to no subtractions from any other individual’s consumption of that good.”
Common impediments to the emergence of public goods are collective action problems (the situation where a number of people acting collectively would all benefit from an action, yet there is an associated cost faced by each individual which makes it implausible that a single actor would be able to or be willing to solve it alone) and related network externality problems (where the benefits to an individual increase the more others also use it – the telephone case).
The Global LEI System presents a classic example of a public good. A common approach to identification would be beneficial for all involved. Yet the incentives for each participant acting alone to develop and introduce such a common system is limited. While some industries have successfully managed to overcome such collective action problems (the Barcode system that has just celebrated its 60th anniversary is a classic example), the finance sector has not been able to achieve that despite several attempts. The result is a series of bespoke proprietary systems developed by individual institutions that use different approaches and cannot be readily linked or integrated, ultimately imposing a deadweight cost for the whole sector and increasing operational risk.
Financial regulatory authorities and the users of financial data share a common objective in resolving this collective action problem. The impetus provided by the Financial Stability Board (FSB) as a coordinator of the global regulatory community for the LEI initiative has the goal of breaking through the collective action problem to enable the global community to agree on a common standard and implement it in a uniform manner. Yet, while regulatory compulsion is viewed by many as a necessary step for the launch and initial adoption of a global data standard, in the long run it is the incentives of users and data providers that are key to support the sustainability and viability of the system. In particular, each participant must have a motivation to adhere to and support the common standard by ensuring high data quality – recognising that this is essential to develop confidence and trust in the system.
The success of the Global LEI System will be determined ultimately by the openness, fairness, and quality of data provided by the system, which are essential to gain the trust of all its participants. That is why the governance model of the Global LEI System is critical – to ensure widespread global adoption the system needs to align the incentives of participants to produce free, accurate and open identification information that is beneficial for all. In the case of the present LEI project, that means addressing the competing tensions between getting a system up and running as quickly as possible to facilitate early use, and the need to ensure that data are of the highest quality. There is a balance to be struck between development of a high quality system that will be useful for many years by global market participants versus hasty implementation that risks making the system unbalanced, error prone, and obsolete.
The agreed launch milestone of March 2013 is focused on the establishment of a solid governance base for the LEI system for the global regulatory community and market participants from different economic sectors that will allow rapid operational implementation of the system. Provision of such a solid global governance framework is a fundamental first step to achieve operational efficiency of the Global LEI System that supports a federated model and local implementation under agreed common standards.
The global initiative is on track. Public and private sector representatives from more than 25 jurisdictions are working on a shared goal in an open and transparent manner. The Charter for the global Regulatory Oversight Committee is being reviewed for final endorsement by the G20. Experts are now focusing on the location of the global LEI Foundation and the fitness criteria and composition of its initial Board of Directors. The Global LEI System governance framework being built will provide a solid platform for the next stage – the operational implementation of a logically centralised database of unique identifiers drawn from Local Operating Units across the globe. There are still challenges ahead. But given the drive and enthusiasm of the public and private sector participants and the strong and active collaboration – early next year should see the delivery of a hitherto elusive key building block towards the public good of strong financial data infrastructure.