As over-the-counter derivatives emerge from the shadowed status of private bilateral contracts into the relative sunlight of clearinghouse operations and regulatory reporting, there is a war heating up about a brand new problem — how these deals will be identified.
Stocks, bonds, exchange-traded derivatives and other financial instruments are all regularly assigned unique codes that enable them to be bought and sold, cleared and settled, risk-assessed, used for collateral, and reported to regulators. OTC derivatives are perhaps the last significant investment realm to fall into step in this well-established parade. But which identifier will be the global standard is up for debate with three different schools of thought emerging.
The issue boiled to the surface in two requests for industry feedback conducted by the European Securities and Markets Association (ESMA) as to a revamping of MiFID’s best execution requirements. The ESMA and powerful standards bodies like the International Organization of Securities Commissions (IOSCO) and the International Organization for Standardization (ISO) are facing a hard choice, assuming they can make a clear-cut choice at all.
The Markets in Financial Instruments Directive (MiFID) is the pan-European legislation passed in 2007 requiring fund managers and broker-dealers to meet best execution requirements for their customers and prove they have done so. Although the MIFID was adopted before the European Markets Infrastructure Regulation (EMIR), there is some overlap when it comes to reporting on derivative trades. EMIR focuses strictly on derivative transactions, while MiFID addresses the full breadth of instrument classes.
The reporting requirement of the two regulations are slightly different. In the case of EMIR, the European version of the US Dodd-Frank Wall Street Reform Act, reports on executed derivative transactions must be sent to an accredited trade repository. MiFID, the European version of the US Reg NMS, requires reports on executed trades in derivatives, equities and bonds to be sent to a so-called Approved Reporting Mechanism (ARM) certified by the Financial Conduct Authority which forwards the information to regulators. Under EMIR, financial firms must report on their derivative trades to a trade repository which is also an accredited reporting mechanism, a task which also fulfills their reporting obligations under MiFID.
In reviewing MiFID for possible changes, the ESMA asked market players to comment on whether they agree with its proposed approach to the use of instrument types when reporting on their trades. If not, they are asked to elaborate on the possible alternative solution of identification of new instruments. Although the question is the 238th one in a string of questions, it appears to have generated plenty of debate, as evidenced by the responses received. The comment period ended on March 5. ESMA will take the responses under consideration when coming up with a new version of MiFID, coined MiFID II. The game plan is for all members of the European Union to transpose the revamped pan-European legislation into local law in 2016.
For exchange-traded derivatives, ISINs issued by national numbering agencies are currently the global standard except in several European countries where Alternative Instrument Identifiers (AIIs) are issued by derivative exchanges. For OTC deals, however, which are now required to be cleared through clearinghouses in the US, and will face similar requirements in the EU in the next few years, there is no established identifying standard.
“Little progress has been made on identification codes for over-the-counter derivatives because it is difficult to determine beyond a high-level explanation of the type of contract what attributes should be included and which identification code can do so,” Joe Halberstadt, director of derivatives messaging for network provider SWIFT in London tells FinOps Report. SWIFT did not answer ESMA’s request for comment on identifiers beyond urging consistency across all markets, a common thread among the responses.
David Nowell, head of industry relations and regulatory compliance for UnaVista, a trade repository and approved reporting mechanism, also points out that the fundamental differences between exchange-traded derivatives and over-the-counter derivatives makes reaching any consensus difficult. “It is essential that exchange-traded derivatives have a unique code for identifying an instrument at the trading and settlement levels, because these standardized instruments are available for many market participants to trade,” he says. “OTC derivatives are different in that they tend to be bespoke contracts and only traded bilaterally.” UnaVista is owned by the London Stock Exchange Group, which commented separately to ESMA.
Although various identifiers are vying for use in regulatory reporting, there is general agreement that a do-what-you-please approach in identifying OTC deals is not the right answer. The use of a variety of codes, proprietary codes or even a descriptive narrative will make it far harder for regulators to monitor systemic risk or catch illegal conduct when plowing through thousands of transaction reports received daily.
The Trio of Choices
In this setting, three identification options have emerged. One promoted by the Association of National Numbering Agencies (ANNA) is to rely on a combination of ISINs and the Classification of Financial Instruments code, or CFI for short. Another, being touted by data giant Bloomberg, is to use an instrument identifier originally developed for use in its proprietary taxonomy, called the Financial Instrument Global Identifier (FIGI). The solution espoused by the International Swaps and Derivatives Association (ISDA) is to depend on its taxonomy, which includes a Unique Product Identifier (UPI) and a Unique Transaction Identifier (UTI).
Which will end up the global standard for derivatives identification is anyone’s guess. Naturally, there are some actual or perceived benefits to each option which its sponsor and entourage of aficionados are only too eager to support. Of course, detractors are equally as eager to highlight shortcomings of others.
On the surface, relying on ISINs for swap contracts sounds like the most ideal solution. After all, the ISIN is a globally recognized standard that is deeply embedded in capital markets operations, and that’s exactly what ANNA is counting on. “We encourage the use of ISIN as the sole instrument identifier for financial instruments including the ultimate underlying instrument,” says the umbrella organization for national numbering agencies in its response to ESMA. ISINs are already assigned for exchange traded derivatives and some OTC derivatives, such as cleared only and flex contracts. Therefore, there is no reason ISINs cannot be extended to all derivatives, and ESMA should either encourage or mandate ISIN as the reporting standard.
In defending the use of ISINs, ANNA is also quick to point out the shortcomings of AIIs. The main purpose behind an instrument code, the organization explains, is that it both uniquely identifies the instrument and enables participants to understand its attributes through associated reference data. AII can’t do that because it is a collection of reference data and not an identification code, has no owner or governing body to enforce consistent usage, and does not have a sufficiently robust methodology to accommodate any other asset classes other than exchange-traded derivatives at best. “The dangers of using an identifier that is not subject to an appropriate governance framework have been highlighted by the use of AIIs within the existing MiFID transaction reporting regime,” concludes ANNA, which serves as the registration authority over ISINs.
However, so far, there haven’t been that many ISINs assigned to swap contracts and some data management experts worry that national numbering agencies will have a hard time expanding the reach of ISINs for over-the-counter derivatives, which can have far more complicated structures than simple equities, debt and exchange-traded instruments. Naturally, ANNA disputes such a stance, saying the ISIN standard has evolved over twenty years and can continue to do so, including addressing the specific needs of the over-the-counter derivatives market.
Emma Kalliomaki, a member of ANNA’s board of directors and head of the London Stock Exchange’s Sedol Masterfile, tells FinOps that there is no reason ISINs can’t be adopted to identify over-the-counter derivatives with the CFI serving as the classification, or more detailed description of the asset class involved.
“All that is required is a clear and defined set of assignment principles that can be applied consistently to OTC instruments. “These standards [the ISIN and CFI] have a clear governance framework which includes contributions from key global and local participants,” says Kalliomaki, who is also the convener for an ISO working group upgrading the CFI standard. National numbering agencies issue CFIs along with ISINs whenever a new security comes to market.
The combination of the ISIN and CFI, Kalliomaki believes, can provide a comprehensive and efficient means of identifying OTC contracts that will also be consistent with the established use of ISO standard identifiers in other asset classes and processing functions. The ISO working group has just completed its upgrading of the CFI to handle over-the-counter derivatives. All that is left is the written formalization of the new guidelines, which would also allow end users to assign CFIs on their own rather than having to wait for national numbering agencies to do so.
What about using other taxonomies and identifiers? They will only add complexity, cost and risk. “At a minimum, the costs involve mapping tasks to correlate the formats and underlying reference data across data management schemas that are alien to one another,” says Kalliomaki. “The reality is more complex and risk-laden when front, middle and back-office functions and technologies have to uphold data quality and integrity while providing straight-through processing among disparate standards, data sources and validation requirements.”
In its letter to ESMA, ISDA does not specifically comment on any competing identification codes, instead noting that it is working with IOSCO on a proprietary taxonomy as the “ideal candidate” for UPI endorsement when it comes to derivatives not traded on an exchange. Although ISDA doesn’t go into any details on its taxonomy in answering ESMA’s question, a separate document on its website describes its taxonomy, indicating that it is based on concatenating the actual description of the asset class, product, sub-product and other details such as the sector of the underlying reference instruments from the different levels of the taxonomy. Neither the maturity of the swaps contract involved nor the comprehensive reference data on the underlying instrument is provided.
Although ISDA was actively involved in udating of the CFI to incorporate over-the-counter derivatives to ensure that the CFI and ISDA taxonomy are aligned, it has also been promoting its own taxonomy as a better solution over CFIs. However, SWIFT’s Halberstadt says that ISDA’s taxonomy may not be granular enough to describe over-the-counter derivatives. ISIN supporters are also concerned that because ISDA’s UPI may not be appropriate to use in the reporting fields for product identifiers in the EMIR and MiFID transaction reports. The reason: the UPI serves as both an identifier and classification. ISDA officials counter that they are open to changes in the taxonomy to met industry and regulatory requirements and will involve regulators in the governance process.
While trade associations such as ANNA and ISDA are keen to promote their own options, data vendor Bloomberg says it has come up with a far better alternative in its FIGI. Its letter to ESMA does not specifically address ISDA’s taxonomy, but Bloomberg is quick to slam both ISINs and AIIs. “We believe that by ESMA allowing the use of FIGIs for regulatory purposes — using an international standard that is non-proprietary, open and free, that addresses all instruments across all asset classes by trading venues, that has its own built in integrity check and that already identifies over 200 million instruments will be to the overall and long-term benefit for trading venues, market infrastructures, and others,” Chris Pickles, the public face of Bloomberg’s open symbology initiative since last fall, tells FinOps. “The support for AIIs is very limited with the investment management industry saying it would be the wrong approach and one major exchange saying the AII doesn’t do the job.”
Just what is a FIGI? Like the ISIN, it is a 12-digit character code. So why does Bloomberg think it is better than ISIN? The major difference between the two is that the FIGI identifies the trading venue. Although ISO-standard group of identifiers provide a Market Identifier Code (MIC) to identify a trading venue when attached to an ISIN. the combination has one glaring shortcoming, according to Bloomberg. The 12-digit FIGI includes a check digit, thereby ensuring the integrity of the FIGI as a whole. While the ISIN includes a check digit, the MIC code does not.
What’s more, claims Pickles, ISINs are now only assigned to about 10 percent of the total universe of instruments which financial firms rely on. However, ISIN supporters believe that Bloomberg’s numbers might be inflated because an instrument would have only one ISIN associated with multiple MICs for trading venues. By contrast, an instrument might have multiple FIGIs depending on the number of places it is traded. Bloomberg, they also say, does have an inherent advantage when it comes to issuing identifiers for swap contracts. When those contracts are traded on the Bloomberg swaps execution facility, it stands to reason Bloomberg already has the identifying data to immediately generate a FIGI.
Who Loves What
How do the alternatives stack up when it comes to their supporters? The ISIN appears to be the favorite among most of the exchanges and some fund management groups which responded to ESMA’s question about identifiers. While pointing out AIIs shortcomings, Germany’s BVI and the European Fund and Asset Management Association (EFAMA) called on internationally accepted numbering standards, as long as their use was free. The BVI specifically cited ISINs as the best option. However, ISDA’s taxonomy, US swap dealers and traders tell FinOps, is favored in the US and is already used when reporting on swap trades to US trade repositories. In its one sentence response to ESMA’s question, Barclays agreed with ISDA’s stance. Derivatives giant Chicago Mercantile Exchange thinks CFIs are the best approach.
Bloomberg’s taxonomy is backed by the Object Management Group (OMG), an organization of data and technology scientists that adopted FIGI last year as their global securities identifier standard. Pickles uses the fact that FIGIs are created and allocated using the OMG’s open global standards to counter any argument that they have no global governance structure.
Among the multitude of exchanges which gave their two cents, the London Stock Exchange’s owner LSEG was the most adamant in insisting that internationally accepted standards should be adopted as far as possible for exchange-traded derivatives. To that end, ISINs should be used as the sole identification scheme as it provides a robust methodology for uniformly identifying financial instruments across all markets and nations. By contrast, the AII is simply a collection of reference data items, says the LSEG. Nasdaq, the Federation of European Securities Exchanges, and the Irish Stock Exchange advocated the use of ISINs where available, but said that ESMA’s reporting field on the identification of new instruments should be optional, rather than mandatory.
UnaVista’s Nowell is in favor of using ISINs for exchange-traded derivatives, but agrees that more thought needs to be put into coming up with a code for OTC derivatives. “Although ISINs can be assigned for OTC derivatives, the concept of unique identifiers for all OTC derivatives may not be feasible due to their bespoke nature,” he says. “A decision needs to be made on whether an identifier for OTC derivatives is actually required or whether a simple classification is more appropriate.” If a simple classification is decided, Nowell believes that the revised CFI code would be the logical choice.
The CME also warned ESMA against the use of proprietary identification codes in favor of a universally global standard. While suggesting a consensus be reached between trading venues and regulatory agencies to create such a unique product identifier, a CFI code could certainly be a good alternative choice and in its letter to ESMA, the CME cited ISO’s work in overhauling the CFI, to bring it in line with the more complex types of contracts now being traded. Although ANNA is promoting the combined use of ISINs and CFIs, the revised CFI standard also allows financial firms needing classification for swap contracts to come up with their own CFIs, based on the formal allocation guidelines to be published this fall.
As the only European securities depository responding to ESMA’s request for comment on identifiers in MiFID reporting, Portugal’s central securities depository was outspoken when it came to endorsing the use of ISINs only for all financial instruments. There is no reason, they can’t be extended to other asset classes, said Interbolsa, which is owned by Euronext. Euroclear, which owns the depositories in the other Euronext markets such as France, the Netherlands and Belgium did not respond to ESMA’s question on identifiers, although it did comment on other aspects of MIFID’s overhaul.