ESMA new edict on ISINs has split the industry but initiatives are underway to find solutions. However, it will still require a significant infrastructure upheaval for those firms that have never used the unique code. Lynn Strongin looks at both sides.
The merging of exchange traded and OTC derivatives may reap benefits but it is not a meeting of the minds. This is especially true when it comes to applying the International Securities Identification Numbers (ISINs). Differences abound but like many relationships, compromises will need to be found.
Unique codes are not a new phenomenon. All stock, bonds, exchange-traded derivatives (ETD) and other financial instruments are all regularly assigned them in order for these assets to be bought and sold, cleared and settled, risk-assessed, used for collateral, and reported to regulators. ISINs, a 12 character code, which are issued by national numbering agencies are currently the global standard used for ETDs in several European countries but there are also many countries that employ the Alternative Instrument Identifiers (AIIs) which are distributed by derivative exchanges. OTC contracts, which are bespoke, but will now be required to go through central clearing have been exempt from needing a universal moniker.
However, last year the European Securities and Markets Authority’s (ESMA) 402-page Draft Regulatory and Implementing Technical Standards dictated that ISIN, a 12 character code, should be the universal code used for all financial instruments including OTC contracts under the MIFIR regime. The regulator defended its position by heralding ISIN’s open source nature, low cost, speed and flexibility. They also noted that as they were already assigned for ETDs and some OTC derivatives, such as cleared only and flex contracts, many firms would not have to start from scratch and build new infrastructure.
Opinions though are divided over its attributes. On the one side, the UK’s Investment Association, the Dutch Fund and Asset Management Association and German investment funds body BVI are supporters and believe they are fit for purpose. Germany’s BVI and the European Fund and Asset Management Association (EFAMA) are also proponents as long as their use is free.
In the opposing camp, the International Swaps and Derivatives Association (ISDA) and the Global Financial Markets Association, have expressed their concerns over technical and competition issues that might arise from mandating the use of ISINs for reporting OTC contracts. Some market participants have also disputed claims that ISIN is flexible or can quickly adapt to changing market conditions. They argue that there is no evidences supporting this and that in fact the necessary protocols in place for revision of ISO standards, which help to protect the standard’s integrity and purpose, can slow down the process of reacting quickly to sudden shifts.
The debate on global identifiers is not new, according to Brian Lynch, CEO of solutions provider Risk Focus. “To some extent I’m sure regulators expected the industry already have a solution but as they didn’t and as there was a lack of viable alternatives, they took the best of what was available. ISIN was chosen because it is well established, it’s an ISO standard and has built in validations. They didn’t want to have to build something new.”
“It is easy to write down in law that ISINs will be used for all financial instruments but it will be far more difficult to apply them to OTC contracts than for equities, bonds and listed derivatives,” says Sassan Danesh managing partner at Etrading Software and Co-Chair OTC Products Committee, FIX Trading Community.
Sassan Danesh, managing partner at Etrading Software and Co-Chair OTC Products Committee, FIX Trading Community, notes that while ISDA has a template for a trade, there has historically been no industry consensus on the definition of the products, which is a pre-condition for the issuance of ISINs. This is not the case say with equities where a prospectus contains the definition of the instrument.
“It is easy to write down in law that ISINs will be used for all financial instruments but it will be far more difficult to apply them to OTC contracts than for equities, bonds and listed derivatives,” he adds. “There are so many variables to capture. For example, applying an ISIN on a 10 year rate swap may sound simple because it is a widely traded instrument but the industry and regulators need to figure out if the instrument definition should include a start and end date or whether these dates should be part of the trade details but not instrument details.”
Other issues for interest rate swaps, according to Danesh include the possibility that the identifier may need to change daily to reflect the variable cash flows on different days and deciding whether the location of its clearinghouse is a material factor in the instrument definition. Further operational questions relate to whether it is better or worse to pre allocate ISINs versus real time creation, both of which will present implementation challenges.
Danesh believes that the current industry led solution is the best way forward and that the ISO Study Group, which is sponsored by the Association of National Numbering Agencies (ANNA) and FIX has addressed many of the issues and developed a game plan which incorporates all of the ISDA resolutions. This includes creating a new special purpose vehicle which will sit under ANNA but also be open to other industry advisory bodies which marks a significant departure than in the past. In addition, an independent consultancy organisation similar to one of the big four accountancy firms will be set up to execute the Request for Proposal (RFP) and seek a suitable service provision partner (SPP) to run the systems and maintain the records as part of the OTC-ISIN service.
Overall cooperation seems to be a theme in financial service circles whether it be for clearing, reference data or collateral management. “Industry collaboration seems to be at an all-time high,” says Lynch. Cost is a driver but so too is complexity. This is because there is no single organisation that can develop all the solutions. In the case of ISIN, there will be a need to manage and control a tremendous amount of data and it will have to be more granular in order to compare like OTC assets.”
For example, under the original MiFID in 2007, financial service firms had to report 28 fields for ISIN, the AII and some OTC instruments. Fast forward to today and the regulation not only expands the number to as many as 90 fields for derivative transactions and all firms including corporates are now in the catchment area.
Not surprisingly it will be a significant undertaking especially for those firms who have not used ISINs. “I think it will be a challenge for the smaller and regional firms,” says Matt Gibbs, product manager for technology provider Linedata. “Most large players already have the infrastructure in place. However, they will have to expand the database to capture the increased number of fields. We also have templates in our system that are flexible so that they can capture the data as it changes.”