The Legal Entity Identifier: the Value of the Unique Counterparty ID

The Legal Entity Identifier: The Value of the Unique Counterparty ID

Contents

Executive Summary 2

The Legal Entity Identifier: A Global Solution for Identifying Trade Counterparties 5

The Business Case for the LEI: From Counterparty Identification to Business Value 10 Capital markets 11 Commercial transactions (B2B commerce) 15 Commercial credit 19

Scaling Adoption of the LEI 22 2 The Legal Entity Identifier: The Value of the Unique Counterparty ID

Executive Summary

When the collapse of Lehman Brothers—at on recommendations developed by the the time the world’s fourth-largest invest- Financial Stability Board, market authori- ment bank—sparked a global financial cri- ties worked with private-sector entities to sis in 2008, regulators and capital markets create the Global Legal Entity Identifier players needed to quickly assess the extent System (Global LEI System), which serves of market participants’ exposure to the as a publicly available, global directory of bank and each of its hundreds of subsidiar- legal entities. ies. Like many other capital markets partic- The Global LEI System assigns 20-digit, ipants, Lehman Brothers transacted from a alphanumeric Legal Entity Identifiers (LEIs) maze of affiliate and subsidiary legal enti- to uniquely identify legal entities partic- ties (Exhibit 1), and there was no standard ipating in transactions worldwide. Each global identification system for each finan- LEI contains information about an entity’s cial counterparty within that maze. Con- ownership structure and thus answers the sequently, financial regulators and market questions “who is who” and “who owns participants found it impossible to reliably whom” among market participants. At assess counterparties’ exposure to Lehman’s present, capital markets participants who entities and to each other. trade over-the-counter (OTC) derivatives The financial crisis thus laid bare the crit- are the early adopters of the LEI, using the ical need for a system to identify and un- unique identifier for transaction reporting derstand exposures at the legal-entity level to regulators. instead of the aggregate, parent-company However, the LEI has much broader poten- level. If it had been available at the time, tial applications; for example, banks can a system that assigns electronic, standard use them to issue loans, and corporations identifiers to legally distinct parties would can use them to verify the identities of their have helped to fill this gap. sellers, suppliers, and other counterparties. The 2008 financial crisis made influential In general, the LEI creates business value organizations like the Group of 20 (G20), in two ways: first, it reduces transactional the Financial Stability Board, and regulators and operational friction in the identifica- keenly aware of the need for a universal tion of transaction counterparties. Second, system to identify legal entities, and they it makes important information about the began to call for its development. Based background of a legal entity in a particular The Legal Entity Identifier: The Value of the Unique Counterparty ID 3

Exhibit 1 Lehman Brothers Holdings Inc. Lehman Neuberger Lehman LB 745 Lehman Lehman LBHIs “Aviation” Lehman Lehman Brothers legal Berman Brothers LLC Brothers ALI subsidiaries (includes Brothers Brothers Holdings Inc. Commercial Inc. CES Aviation LLC, CES Bancorp OTC entity structure LLC Corporation Aviation V LLC and CES Inc. Derivatives Aviation IX LLC) Inc.

Aurora Bank, 1. Woodlands Commercial Bank FDB 2. Lehman Brothers Trust ...... Company N.A. . . . ENC 3. Lehman Brothers Trust Mortgage Company of Delaware LLC

Lehman Lehman Lehman Property LBI Lehman Leveraged Brothers Brothers Brothers Asset Group Commercial Loan Trading ...... Special Derivative Financial Manage- Inc. Paper Inc. Holding Financing Products Products ment Inc. Partners Lab Inc. Inc. . . . Leveraged Lehman Fondo de Lehman PAMI Structured East Meril Loan Trading Brothers Inversion Scottish LLC Asset Dover LLC Holdings Inc. Commodity Multimerca Finance . . . Securities Limited . . . Services do Credito L.P. Corp. Luxembourg Inc. Privado Trading Finance S.a.r.l. . . . LB Rose PAMI LB LB LB 2080 Luxembourg Ranch Stadler Somerset Preferred Kalakaua Residential LLC Arms LLC Somerset Owners . . . Properties LLC LLC LLC Loan Finance . . . S.a.r.l

Note: Blank boxes for illustrative purposes Source: SEC ling

transaction more accessible and traceable. division recently found that it had an aver- Collectively, these benefits reduce the time age of five names—with minor variations spent on identifying counterparties and im- in its database—for the same organization. prove the reliability of information. Additionally, commonly used databases and different divisions and IT systems within Current identification and verification organizations can all have varying versions processes have significant manual compo- of the same entity’s name, making it harder nents and often require the use of multiple to trace and to link information from databases in which a counterparty may be multiple sources. identified by different names. Many banks and corporations still use names rather This paper discusses three use cases that than identifiers, resulting in confusion. As demonstrate the wide potential application an example, a large bank’s client services of the LEI. These use cases—which are not 4 The Legal Entity Identifier: The Value of the Unique Counterparty ID

meant to be exhaustive—relate to capital ance of letters of credit. Further savings are markets, commercial transactions, and the likely from the reduction of spend on seller extension of commercial credit. The use identification for e-invoicing, and from a cases and benefits are especially relevant more automated process for commercial to large corporations, small businesses credit extension. and their banking institutions, and in- The use cases described in this paper repre- vestment banks. sent a small percentage of potential savings. In capital markets, the LEI’s primary Introducing the LEI into almost any process value is derived from reducing the cost that requires identification and verification of onboarding clients and of middle- and of a counterparty—and that has a manual back-office activities related to the process- component—can deliver efficiencies and ing of stocks, bonds, and other securities greater reliability. trades. In commercial transactions, LEIs en- As with any identifier, the broad applica- able faster processing of letters of credit and tion of the LEI depends on network effects better identification of sellers on e-invoicing within each industry subgroup. Key benefi- networks. And in the process of extending ciaries of new uses of the LEI should work commercial credit, the use of the LEI allows with each other and their counterparties to for more robust and efficient know your discuss the adoption of the LEI in day-to- customer (KYC) diligence on borrowers, as day processes. well as better traceability of information on borrowers from multiple sources. □ □ □

These benefits yield quantifiable value. Our This paper is a collaborative effort by the analysis suggests that savings of at least Global LEI Foundation and McKinsey & 10 percent of total operations costs for cli- Company to increase awareness of the LEI, ent onboarding and trading processing for including the potential capabilities and banks adopting the LEI are possible. For business benefits afforded by LEI adoption. the broader investment banking industry McKinsey served as a knowledge partner alone, this would yield savings of over $150 to GLEIF in researching and writing the million annually. Banks in trade financing paper. In the pages that follow, we explain could save an additional $500 million per the LEI in detail and describe three import- annum overall by using the LEI in the issu- ant use cases. The Legal Entity Identifier: The Value of the Unique Counterparty ID 5

The Legal Entity Identifier: A Global Solution for Identifying Trade Counterparties

The LEI and its beginnings The 2008 collapse of the world’s That maze still exists, and is further com- fourth-largest investment bank, Lehman plicated by the fact that most entities have Brothers, and the subsequent global finan- multiple identifiers that are used for differ- cial crisis exposed—among many other ent purposes. For example, local business systemic vulnerabilities—a critical need register codes that vary by country of incor- to implement a system that would assign poration, tax identification numbers such unique identifiers to legally distinct entities. as the Value-Added Tax (VAT) number in After Lehman’s demise, participants in the the European Union (EU) or the Employer global financial system could not assess Identification Numbers (EIN) in the United their exposure to Lehman, its subsidiaries, States, various sectors’ company registers and each other because there was no stan- such as the Commercial and Government En- dard system for identifying counterparties tity codes for U.S. defense contractors, and in the maze of subsidiaries and affiliates payments I.D.s such as the Business Identifier from which banks, insurers, asset manag- Code (BIC). ers, and other market participants transact. Moreover, many entities share their names The needed information was technically or part of their names with other, similar en- available somewhere among the thousands tities. For example, a bank can have multiple of documents signed by Lehman’s hundreds identifiers and share its name, or part of its of subsidiaries—which in turn were trad- name, with many other banks, making accu- ing with hundreds of subsidiaries of other rate data aggregation and validation difficult market participants—but without a consis- (Exhibit 2). tent identifier for each entity, no electronic system could determine individual market The lack of consistent, unique identifiers for participants’ risk or how participants were entities can have dire consequences. It is now connected to each other. widely accepted that financial institutions’ 6 The Legal Entity Identifier: The Value of the Unique Counterparty ID

Exhibit 2

Multiple Hypothetical, based on real examples identiers, common name Entity ABC National Bank in California

RSSD1 ID = 77812

2 Multiple FDIC Certicate ID = 41652 existing SEC CIK3 = 571060 identi ers ISO BIC4 = ABCNUSX8 CUSIP5 and various Vendor IDs = Proprietary

Entities with 12 banks named ABC National Bank overlapping 131 banks with a variant of the name ABC National Bank names

1 Replication Server System Database (assigned by the Federal Reserve Bank) 2 Federal Deposit Insurance Corporation 3 Securities and Exchange Commission, Central Index Key 4 International Organization for Standardization business identier code 5 Committee on Uniform Security Identication Procedures Source: McKinsey

failure to monitor their counterparty activ- Based on recommendations developed by ities at the legal entity level contributed sig- the Financial Stability Board and endorsed nificantly to the crisis and its repercussions. by G20, market authorities worked with the private sector to develop the Global LEI Over the years, private-sector firms and System. This identification system assigns industry associations had made attempts to electronic, 20-digit, standard identifiers— establish a standardized legal entity iden- LEIs—that include “business card informa- tification system, but were unable to suf- tion” reference data and uniquely identify ficiently coordinate their efforts to launch legally distinct parties, thereby allowing fi- a single, worldwide solution. In the wake nancial connections to be identified, mapped, of the 2008 crisis, however, the Financial and linked. To ensure data quality and in- Stability Board and G20 marshaled a con- teroperability across systems and networks, sistent, coordinated, global commitment to the LEI is based on the ISO 17442 standard act in the public interest and create such developed by the International Organization a system. for Standardization. The Legal Entity Identifier: The Value of the Unique Counterparty ID 7

The business card information available with the LEI Regulatory Oversight Committee the LEI reference data—the official name of (LEI ROC) and the Global LEI Foundation a legal entity and its registered address—an- (GLEIF) (Exhibit 3, page 8). This struc- swers the question of “who is who” among ture ensures the accuracy and integrity of entities. Currently, the LEI data pool is being the reference data recorded under the LEI gradually enhanced to include information of each entity. that answers the question of “who owns To facilitate efficient acquisition of LEIs and whom.” This data can be used to identify a to ensure high data quality, the Global LEI legal entity’s direct and ultimate parents so System is set up as a federated system under that individual companies can be sufficiently which several LEI-issuing organizations (LEI researched. Parent company information is issuers) act as the primary interface for legal expected to become available for most of the entities wishing to obtain an LEI. These LEI LEI population in the first half of 2018 at issuers provide registration and renewal the latest. services while also offering in-depth knowledge of local markets and helping to over- come language barriers between customers Since the establishment of the and suppliers.

LEI system, a series of regulatory The process of ensuring LEI data quality initiatives have urged—and in some starts when an entity “self-registers” to obtain an LEI. The entity must provide cases required—market participants accurate legal entity reference data when to adopt unique, cross-industry legal it registers; the LEI issuer must then verify that reference data with a local, authori- entity identifiers. tative source—e.g., a business register— and issue an LEI that complies with the LEI standard. Since the establishment of the LEI system, a series of regulatory initiatives have The annual renewal process for the LEI urged—and in some cases required—market further assures the quality of the reference participants to adopt unique, cross-industry data. While legal entities are required to legal entity identifiers. These initiatives have notify their managing LEI issuers of changes included the Dodd-Frank Act in the United to their legal entity reference data, the States and the forthcoming revised EU annual renewal process ensures that each Markets in Financial Instruments Directive legal entity and their LEI issuer review and (MiFID II) and Regulation (MiFIR). re-validate the legal entity’s reference data each year.

Strong governance, readily obtain- The annual renewal requirement distin- able, and easily searchable guishes the LEI from other identifiers in The Global LEI System is supported by a two ways: three-tier governance structure that includes 8 The Legal Entity Identifier: The Value of the Unique Counterparty ID

Exhibit 3 The Financial Stability Board and the G20 have The Global endorsed the LEI, Global LEI System and GLEIF LEI System LEI Regulatory Oversight Committee (LEI ROC) Represents public nancial market authorities from around the world ROC Coordinates and oversees the Global LEI System, a worldwide framework of legal entity identi cation

Global Legal Entity Identi er Foundation (GLEIF) Ensures the operational integrity of the Global LEI System Monitors and manages LEI data quality Makes available the technical GLEIF infrastructure to access the full global LEI repository free of charge to users

LEI Issuers LEI Issuers Issue LEIs to legal entities

Source: GLEIF

1. No other global, open entity identification A legal entity is not limited to using an LEI system has a comparably strict regime of issuer in its own country; rather, it can use regular data verification. the registration services of any LEI issuer that is accredited and qualified to validate 2. Data users can see when the information LEI registrations within its jurisdiction. related to a specific LEI was last verified. At the end of June 2017, 30 LEI-issuing The Global LEI System is designed to en- organizations were managing more than courage competition among LEI issuers. The 520,000 LEIs representing legal entities in LEI issuer sets the amount of the fees for is- 200 countries. suance and maintenance of an LEI, but these The LEI system provides online search ca- fees must be cost-based. As of July 2017, pabilities through its Global LEI Index, a fees ranged from $75 to $219 per entity, but central repository of open, standardized, his- most LEI issuers grant bulk discounts. torical, and current LEI reference data. Any The Legal Entity Identifier: The Value of the Unique Counterparty ID 9

interested party can access and search the segments could save costs, expedite the complete LEI data pool free of charge using execution of transactions, and improve risk the web-based LEI search tool. management for individual firms and the entire market. The three broad use cases in the Establishing the Global LEI Index as the following section demonstrate the potential primary source of reference data identify- value and impact of secure, instantaneous ing corporations of all sizes and market counterparty identification. 10 The Legal Entity Identifier: The Value of the Unique Counterparty ID

The Business Case for the LEI: From Counterparty Identification to Business Value

The LEI has business value in two facilitate interaction among platforms, broad areas: enhance reliability by providing a “single source of truth,” and decrease the incidence 1. It reduces transactional and operational of exceptions. friction, both within and among organizations.

For example, within an organization, the The need for the LEI use of the LEI can facilitate more efficient, Identifying the entities with which an organi- precise communication among functional zation does business can be time-consuming, departments and business units. Across dif- costly, and complex, especially since most ferent systems and organizations, the LEI can organizations use multiple identifiers in mul- simplify and expedite reconciliation among tiple systems for their existing or prospective different systems or networks, enabling clients, business partners, and counterpar- faster identity verification when using multi- ties. For example, a corporation commis- ple data sources. sioning a seller’s services may have several internal identification (I.D.) numbers for the 2. They make important information about same seller: an I.D. number in their seller the background of a legal entity in a transac- onboarding system, another I.D. number in tion more accessible and traceable. their seller management and invoicing sys- For example, commercial credit providers tem, and a third in their legal department’s could use the LEI to verify an entity’s own- document management system. ership structure before granting credit, and Meanwhile, local corporate registers, in- banks could use them to match multiple legal dustry associations and utilities, exchanges, documents to a client when processing a spe- credit bureaus, customs and tax authorities, cific transaction. and other market infrastructure players each These benefits apply to a range of business maintain their own identification numbers settings. When widely deployed, the LEI for the same entity. This situation makes reduces the time spent on manual tasks, it nearly impossible to determine which of The Legal Entity Identifier: The Value of the Unique Counterparty ID 11

these organizations has a relationship with a which are not exhaustive—span 1) capital particular entity and has approved that en- markets, 2) commercial transactions and 3) tity as a credible counterparty. the extension of commercial credit. They discuss the types—and in some cases the magni- Consequently, a corporation seeking to tude—of benefits that can be realized. verify the identity of a legal entity that it is considering as a counterparty for a specific In these use case examples, the LEI yields transaction must spend significant time and benefits throughout the lifecycles of both the resources trying to collate and properly attri- customer relationship and the transaction. It bute the information available on that entity. does so by reducing friction in key processes Once gathered, the information can often and by enhancing traceability and access be contradictory and sometimes ineffective to information. for identification. Capital markets: Securities trade The reliable, instantaneous identification processing, client onboarding, and of an entity through its LEI can create real client documentation business value by expediting transactions The origins of LEI adoption in capital markets and the exchange of payments. Moreover, by providing information about “who is who” Market participants involved in OTC deriv- and “who owns whom” among entities, the atives trading were the first to widely adopt LEI also enables better traceability within and use LEIs. In the United States, the Dodd- and across organizations. A single LEI can be Frank Act’s requirement that entities report used to obtain information about ownership their OTC derivatives activity sparked a and parent-subsidiary relationships to facili- push toward implementing an identification tate checks for multiple invoicing, for exam- system for such entities. With its rules on ple, or to verify the parent company’s credit the implementation of the Dodd-Frank Act, capacity based on its subsidiaries’ assets. the U.S. Commodity Futures Trading Com- mission (CFTC) specified the use of the LEI. Select business use cases In Europe, the use of the LEI was mandated by, for example, the European Market Infra- The use of LEIs as a common identifier for structure Regulation (EMIR). entities has a wide range of business use cases—for industry utilities and databases, Current use of the LEI in capital markets, be- market authorities, and a corporation’s own yond OTC derivatives internal systems. These business cases span multiple industries, business activities, and Once they had obtained LEIs, banks discov- functions, and the benefits accrue to both ered benefits beyond the ability to instan- individual market participants and the entire taneously identify counterparties in OTC business community. derivatives transactions. In particular, banks have found that the LEIs has additional ap- The following sections describe select use plications that span the entire lifecycle of the cases for the LEI that illustrate the breadth client relationship—from the pre-onboarding of its potential applications. The use cases— phase through conducting the necessary on- 12 The Legal Entity Identifier: The Value of the Unique Counterparty ID

boarding checks, signing trading documents, which use a different identifier for the same and trading with the client. entity (Exhibit 4). This lack of consistency forces banks to spend considerable time and Adoption of the LEI for uses beyond OTC resources on the effort to attribute the right derivatives varies across the industry. Several information to the client that they are seek- investment banks are already leveraging the ing to onboard. LEI during the trading phase of the client relationship to reconcile information related to To further complicate this effort, different their clients’ positions, both within the bank areas of the same bank may use different and externally with their clients. At one identifiers for the same client, and vendors global universal bank, internal operations engaged by the bank to assist in the collec- teams use the LEI as the primary attribute tion of KYC-related information may use that aggregates and reconciles client trade in- their own identifiers as well. As a result, formation, which is often stored in disparate what should be a simple task—collecting and internal systems and tagged under different maintaining client information—becomes a client I.D. numbers. This bank found that complex, time-consuming, and resource-in- internal communications and trade reconcil- tensive effort. If all players in the onboarding iation-related tasks have been simplified and process tagged client information with an expedited through the use of LEIs. LEI, client identification would be much more efficient and transparent. Client onboarding has emerged as another area where banks are beginning to use the Once a client has completed the KYC phase, LEI as an effective identifier. A detailed specific documents need to be signed before description of the benefits of LEI use in on- the client can trade various products. Tra- boarding follows below. Banks that have ditionally, the documents are tagged with yet to adopt the LEI in trade processing or an internal legal entity I.D.; however, once onboarding could reap benefits in terms accounts are opened for the counterparty, of efficiency, speed, and improved client the account number replaces the legal I.D. as service. The benefits to all banks would be the key identifier for the client. At this point, significantly enhanced if a greater number of the bank misses the chance to establish a legal entities obtained LEIs. common identifier that can link the client’s account with the signed documentation that LEIs and client onboarding: KYC and docu- allows the client to trade. mentation management The consequences of missing this oppor- The LEI could be leveraged more broadly tunity can be dire. For example, a client, during the onboarding phase of the client re- needing to raise cash quickly to pay obliga- lationship, particularly for activities related tions, might put in an order to sell a bond to KYC requirements and documentation or a stock. If the bank cannot immediately management. In KYC processes, firms work locate the documents showing that the client to verify their client’s identity by conducting can enter into this type of trade, the client’s due diligence. They aggregate information account could be blocked from trading. False from various databases and utilities, each of positives are also a frequent problem: on The Legal Entity Identifier: The Value of the Unique Counterparty ID 13

Exhibit 4 Identiers used by different sources of Different information for a single client identiers are used for the same client ISO BIC by different databases Thomson Reuters PERM ID

Markit RED Entity Codes

Client A Bank A Accuity Bankers Almanac

Taxpayer Identication Numbers (TIN)

Employer Identication Number (EIN)

average, almost 50 percent of AML alerts kets client takes an average of 120 days, ac- potentially blocking a client from trading are cording to McKinsey. If market participants false positives, according to a survey by the broadly adopted the LEI, then the onboard- Association of Certified Anti-Money Laun- ing teams who spend much of their time dering Specialists (ACAMS) and Dow Jones. identifying legal entities and tagging that A third of the respondents to the survey said information to the appropriate data could be that more than 75 percent of AML alerts are made available for other functions. Further, found to be false positives. the time required to onboard clients could be materially shortened so that banks could Beyond simplifying processes and ensuring start trading with their clients much sooner, good customer service, LEIs can expand FTE thereby improving time to revenue. capacity and enable banks to do business with clients faster. Investment banks typi- Based on its Capital Markets Trade Pro- cally employ 1,000 to 1,500 FTEs who focus cessing Survey, McKinsey estimates that on onboarding. Onboarding a capital mar- approximately one-third of the industry’s 14 The Legal Entity Identifier: The Value of the Unique Counterparty ID

operating costs of $5 billion is spent on ac- trade processing could reduce annual trade tivities such as client onboarding, client trade processing and onboarding costs by 10 reconciliations, trade allocations to clients, percent. This would lead to a 3.5 percent and verification of client reference data. reduction in overall capital markets opera- All such activities could be simplified and tions costs, amounting to over $150 million streamlined if LEI use were more broadly in annual savings for the global investment adopted throughout the lifecycle of the cli- banking industry alone. ent relationship. The use of the LEI in the There are several uses for the LEI throughout onboarding and trading phases of the client the lifecycle of the bank-client relationship; relationship would reduce the time spent on currently the LEI is only leveraged for a data correction and reconciliation necessi- subset of the potential applications. Broader tated by inconsistent identification of legal application could have business benefits for entities (Exhibit 5). banks beyond savings related to operational We estimate that introducing the LEI into costs. Specifically, banks could expect to capital market onboarding and securities gather additional revenue by shortening

Exhibit 5 Annual operations costs — Global investment banks LEIs can Percentage help reduce 100%

operational ~15% costs in several capital markets ~10% processes ~5% ~5% 65%

Total operations Trade Reference Service query Client Other cost s enrichment, data and suppo rt onboarding allocation, reconciliations amendmen t

~35% of total trade processing costs can be streamlined through the use of LEIs There is potential to optimize 10% of these costs, leading to 3.5% reduction in total operations costs

Source: McKinsey estimates based on expert interviews The Legal Entity Identifier: The Value of the Unique Counterparty ID 15

the “time to market” for trading with cus- In the lifecycle of commercial transac- tomers while simultaneously improving the tions—especially international transac- client experience. tions— several manual, time-consuming activities are required to complete the Commercial transactions (B2B transaction. In particular, verifying the commerce): Trade finance and identities of counterparties often involves e-invoicing a great deal of manual processing. The use The commercial transaction lifecycle of the LEI could automate identity verification and—as described below—enable The commercial transaction lifecycle involves the digitization of several of the activities ordering goods, sending invoices for the required in the invoicing and trade finance goods, obtaining trade financing, producing steps of a commercial transaction. It could the goods, reconciling payment, and deliver- even potentially reduce the time required to ing/receiving the goods (Exhibit 6). Of these exchange payments. steps, the LEI could have the most impact on invoicing and trade finance.

Exhibit 6 Highest impact of LEI use Key steps in international B2B trade

Delivery/ receipt of Payment goods reconciliation Production and shipment Trade nance, Commercial including: invoice Issuance Ordering/ of letters of credit contract Pre- and post- shipment nance 16 The Legal Entity Identifier: The Value of the Unique Counterparty ID

Exhibit 7

Using a letter 1 Importer and exporter sign trade contract.

of credit 2 Exporter provides commercial invoice. Importer (buyer) Exporter Importer can collect the goods after obtaining to facilitate as applicant 13 (seller) payments in a the documents. cross-border

transaction 3 11 12 6 6 5 7 8 Importer Issuing Importer pays Exporter Exporter Advising Exporter Bank, upon applies bank LC balance ships ships bank informs approving the for LC informs and interest goods to goods to advises advising application, pays with importer after deducting importer importer exporter bank of exporter after de- issuing to collect the guarantee. after Warehouse after of LC. the trans- ducting relevant bank. the docu- The LC receiving receiving action. expenses from ments. balance may LC. LC. negotiation revolve into a amount. loan.

Issuing bank issues LC and informs 4 exporter’s bank. Advising bank mails drafts and documents Issuing bank 9 to issuing bank for reimbursement. Advising bank (importer’s bank) (exporter’s bank) 10 Issuing bank pays advising bank.

Source: GLEIF; McKinsey & Company

LEIs and trade finance After completing the necessary identity checks and verifying the relevant documents, Trade finance encompasses a broad range of the buyer’s bank issues the LC in the buyer’s products and services that facilitate interna- country and sends the LC to the seller’s local tional trade. In the application most relevant bank. The buyer’s bank and subsequently the to LEIs, buyers obtain letters of credit (LCs) seller’s bank must confirm the buyer’s and or bills of exchange from their banks to fa- seller’s identities—a manual, time-consuming cilitate payments to sellers, and sellers use process, as unique identifiers for the seller purchase orders or invoices to obtain financ- and the buyer are not included in the SWIFT ing for production and purchase. (Society for Worldwide Interbank Finan- The process of acquiring and using letters cial Telecommunication) messages between of credit is time-consuming and typically the banks. involves multiple steps, many of which To mitigate risk and comply with AML reg- require identity checks and reconciliation ulations, both the buyer’s bank and the sell- (Exhibit 7). The Legal Entity Identifier: The Value of the Unique Counterparty ID 17

er’s bank must conduct several counterparty In addition to facilitating AML efforts, checks, including: gathering information on the use of the LEI can mitigate fraud risk. the nature of each counterparty’s business; Using an entity’s LEI, a seller’s bank could identifying the buyer’s and seller’s sources of trace outstanding invoices to identify suspi- funding; confirming that the buyer or seller cious activity like multiple invoices for the is not trading in or from a country under em- same shipment. bargo; and ensuring that the buyer or seller Essentially, the LEI makes two key activities does not appear on any trade blacklists. in a complicated process—verification of These controls, too, rely heavily on manual entities and tracking an entity’s history— processing and paper documentation. More- far simpler. over, banks must use a number of databases to perform these checks, but they can only On an annual basis, banks could potentially search by entity name, which creates signif- collectively save between $250 million to icant risk since multiple entities may have $500 million per annum if LEIs were used similar names. to identify international entities and to automate the tracing of their history for the issuance of letters of credit.1 At its maximum “The LEI would help at every level. potential, these savings could represent four The current process is very messy. percent of the current global trade operations cost base. The lower end of this esti- The reduction of false mate assumes high adoption in Europe and positives would be a clear and North America with low adoption in Asia, while the higher end of the estimate assumes significant improvement.” high adoption globally. – Former head of trade finance at large global bank The estimate is derived from two sources of savings: the reduction of time spent on cur- These manual checks could be stream- rently manual checks by about five minutes lined considerably and made far less costly (on a weighted-average basis) for each letter through the adoption of the LEI. LEIs would of credit and the elimination of false posi- enable the immediate, digitized identification tives during the multiple checks. Through of entities and would allow banks to dramat- the use of LEIs and subsequent automation, ically curtail the time and resources spent on the time spent on manual counterparty iden-

1 Value based on 48 million LCs per background checks and investigations. These tification and background checks could be year, estimated by using the total reduced by up to a third. number of SWIFT (MT700 only) mes- efficiencies would be compounded by re- sages. The estimate of average savings ducing the incidence of false positives based per LC has been derived by assuming In addition to these efficiencies, the a savings of five minutes per LC that on AML and other compliance lists. Rather use of LEIs would also facilitate bet- are currently spent on manual tasks. than searching by name, institutions could Sixty percent of LCs are impacted in ter risk management by allowing banks the lower end of the estimate, and 90 simply search the relevant databases using percent are impacted in the higher to maintain a more holistic view of the end of the estimate. We assume 15 each entity’s unique LEI—or, in an advanced percent of total LCs are false positives transacting entity. that require additional manual inter- stage, using a single database. vention and a savings of an additional 10 minutes for these LCs. 18 The Legal Entity Identifier: The Value of the Unique Counterparty ID

LEIs and e-invoicing in both the initial identification of sellers as well as the subsequent updating of records. Like any paper-based process, invoicing An LEI system would make seller data recon- is manually intensive and prone to human ciliation for buyers more efficient and signifi- error, which drives up costs and lengthens cantly reduce costs; specifically, businesses processing lifecycles. Digitizing invoices to could decrease the staff needed to manage enable “e-invoicing,” or online invoicing, seller information and lower the costs associ- reduces these costs and expedites process- ated with auditing and failed audits. ing. In e-invoicing, suppliers are assigned a unique, numerical identifier, which is auto- Use of the LEI could also curb the inci- matically validated upon invoicing. dence of mandate fraud, in which criminals misdirect funds into their own accounts The LEI would have tangible benefits for by pretending to act as the original entity. buyers and e-invoicing networks. Faster, Buyers would have more current informa- more reliable identification and verification tion on their sellers and a more reliable of seller entities would reduce time spent on identifier, which would help detect any manual verification and data consistency attempts to fraudulently reroute funds. Ad- checks while also potentially curbing the ditionally, buyers could potentially access incidence of fraud. While the current global a wider range of sellers, as they could more adoption of e-invoicing is nascent2 and var- reliably verify the identities of smaller or ies by region—representing 2.25 percent of international sellers. invoices in Europe, 3.75 percent in Latin America, 2 percent in North America, and E-invoicing networks are not mandated 1 percent in the Asia–Pacific region—the to verify the identity of each seller that adoption of the LEI could further accelerate buyers add on to their platform; however, the use of e-invoicing as a standard due to they do provide additional identification, the benefits described below. verification, and completeness checks as a value-added service to buyers. Further, e-in- Before engaging in transactions with sell- voicing networks are increasingly providing ers, buyers perform identification checks to supply chain finance services in the form of ensure that sellers are reliable counterpar- early payments against invoices and dynamic ties. This is especially true for large buyers discounts based on timing of payments by transacting with smaller sellers as they at- buyers. Verifying sellers’ identities on be- tempt to comply with the Sarbanes-Oxley half of buyers and providing supply chain Act (2002) in the United States or the EU finance services based on invoices both re- Directives (2009, also known as EuroSox), quire e-invoicing networks to perform KYC, which impose corporate governance norms AML, and sanctions checks on sellers. These on corporations. These include compliance checks are especially time-consuming when requirements related to identification of sell- performed for sellers that are small or based ers as well as the need to periodically update in locations with limited data sources. The records on seller data. success of e-invoicing networks and supply 2 “E-Invoicing/E-Billing - Signifi- The use of an LEI could mitigate operational chain finance platforms depends on the cant market transition lies ahead,” Bruno Koch, Billentis, May 2017 friction and introduce enhanced traceability The Legal Entity Identifier: The Value of the Unique Counterparty ID 19

Exhibit 8 Potential supply 1 Supplier sends invoice to buyer. chain nance Buyer Supplier 3 Suppliers view receivables via web and have option to offer to sell receivables ow with use before maturity date for early payment. of LEI

Public LEI databse E-invoice 2 Buyer submits approved network invoices electronically to the network. 4 Network or platform veries supplier identity through LEI, speeding up KYC and AML checks as well as increasing reliability of information.

6 At maturity date, clearing account 5 Banking partner, acting on behalf is instructed by the network to of e-invoice network, receives and either pay supplier or pay banking reviews early payment requests partner if receivable was sold for Banking and provides funding to supplier early payment. Partner based on buyer’s risk prole.

Source: GLEIF

number of buyers and suppliers that join the platforms by eliminating the need to stan- network or platform. By offering the val- dardize different identifiers. The use of an ue-added seller verification service, e-invoic- LEI would also curtail the need to have mul- ing networks can encourage more buyers to tiple forms of customized identifiers based join their platform. on buyer requirements. Widespread adoption of LEIs would enable standardization across Similar to the benefit to banks, the use of an platforms and countries, further encouraging LEI would reduce the time spent by e-invoic- the use of e-invoicing on networks. ing networks on manual checks across multiple databases and enhance the traceability Commercial credit: Use cases across and reliability of information (Exhibit 8). the commercial credit lifecycle Further, while current interoperability Before extending credit to commercial among platforms is low, the availability of a borrowers, a lender must ascertain the unique identifier would significantly improve borrowing entity’s identity, history, and buyers’ and sellers’ ability to transact across ownership group-structure. This task is 20 The Legal Entity Identifier: The Value of the Unique Counterparty ID

Exhibit 9 Steps where adoption of LEI would be most bene cial Lifecycle of

commercial Portfolio credit Origination Underwriting Administration Management

transactions Identi cation of Draft credit application Contract preparation, Review of account potential customers validation, signing risk using internal and Customer rating external data Initial meeting with Collection and client (data/document Risk analysis veri cation of Monitoring of collection) (forward-looking) documents for changes in account disbursement performance Pre-rating of client Collateral valuation and initial limits for Customer onboarding Assessment of impact product Finalization of credit (including nal AML of new loans on existing application checks) account across all Initial offer platforms Transaction approval Collateral recording and Selection of products and disbursement Recommendation on collaterals Price modi cation and potential modi cations adjustment (if needed) Archiving Data and document preparation/collection Conditional approval

Source: McKinsey

complicated by the fact that corporate customers. Sharing data within and across groups and small businesses often include institutions to manage risk and exposure multiple entities with similar names. In the becomes complicated without a unique iden- United States alone, there are more than tifier that all market participants agree on. 18 million small businesses with revenues Broadly speaking, the commercial credit life- less than $10 million, and 183,000 firms cycle unfolds in four key phases: origination, with revenues between $10 million and underwriting, administration, and portfolio $1 billion.3 Moreover, each of these entities management (Exhibit 9). During each of can interact with the financial system in mul- these phases, various checks are required to tiple ways and across multiple institutions, trace the borrowing entity’s identity, history, often internationally. and ownership. Since these checks involve In this context, lenders—who often have accessing multiple external and internal da- 3 “The Middle Market Power Index: Fueling The Nation’s Economic siloed IT and data systems—may find it tabases, they are often highly manual and Growth,” American Express and difficult to unambiguously identify unique time-consuming, and the integrity of the Dun & Bradstreet, June 2016 The Legal Entity Identifier: The Value of the Unique Counterparty ID 21

collected data can be questionable. Further, small and medium size businesses as well as entities often apply for multiple loans at affiliates of larger groups. The use of an LEI different times, increasing the importance of would help to standardize this vital infor- clear traceability and reconciliation across mation and thus would significantly reduce different data sources, systems, functions, the time that banks’ middle and back offices and business units. spend on manual verification processes.

The ability to easily and accurately trace an “Often, when a smaller business entity’s history is even more helpful during the underwriting phase, when the final risk fills out an application, they give us analyses and credit approval are undertaken. different or variants of the legal names. During the administration phase, when an entity is being on-boarded to the lender’s It’s not uncommon for us to have two systems, the use of a single identifier would different products with different legal strengthen and accelerate the required AML and compliance checks. names listed. [This] creates a mess in After the loan is issued and the portfolio the middle and back office. A way to management phase begins, the lender must standardize this would be great.” use internal and external data to review account risk while also monitoring changes in – Head of commercial lending strategy at a top-five global account performance. These tasks require a financial institution considerable amount of data reconciliation to ensure an up-to-date, accurate assessment During the origination phase, having correct, of the borrowing entity’s risk profile based verifiable information about the entity’s on its financial health, legal background, and identity, history with the bank, and external transactions. The use of LEIs here would ex- financial/lending history is crucial so that pedite data reconciliation and help to ensure appropriate products may be offered and its accuracy. risk can be assessed accurately. Often when entities fill out application forms, they fail In all four phases, the use of an LEI would to enter their complete name, or they enter a facilitate the automation and digitization of variation of the entity name previously used. processes by providing a new data field that This tendency is especially prevalent among could be standardized across all systems. 22 The Legal Entity Identifier: The Value of the Unique Counterparty ID

Scaling Adoption of the LEI

To realize the full potential of the LEI, a An encouraging sign of LEI adoption in substantial number of businesses would emerging technologies is the potential adop- need to adopt it to set the necessary net- tion by R3, an enterprise software firm cur- work effects in motion. In the near term, rently working with a consortium of more adoption can begin with select use cases than 80 banks. R3 is building an operating that build on LEIs’ current use in capital system, based on Distributed Ledger Tech- markets. This initial application will help nology, that facilitates more efficient and strengthen and refine the LEI value proposi- reliable communication and transaction pro- tion for all stakeholders. cessing within and across banking systems. As a first step, R3 is considering using the Discussion among the primary LEI benefi- LEI as the primary identifier embedded in its ciaries and users for specific use cases is ex- digital certificates, which are used to confirm pected to encourage adoption. Banks would the identity of a transacting identity. play a major role in driving adoption in trade finance and commercial lending and The use of the LEI as a default identifier by thus should consider innovative approaches distributed-ledger-based technologies and to encouraging adoption among customers, other emerging technologies demonstrates particularly small businesses. Simultane- how adoption can be leveraged to scale up ously, adoption by regulators who signed to industry-wide implementation of the LEI. the charter of the LEI Regulatory Oversight In such applications, the LEI would provide Committee4 in 2012 and have yet to add the the tangible benefits described—reduction of LEI to their rulebooks could provide addi- friction and information traceability—while tional impetus for adoption. also curtailing the implementation costs of adding a new identifier to existing pro- To become a feasible standard, the LEI cesses. As the adoption of these innovative must be able to work within existing sys- technologies proliferates, the LEI would add tems as adoption increases. An example is value by bringing additional efficiency to the GLEIF’s plan to reconcile to and confirm new technology. SWIFT’s full BIC-to-LEI mapping. The 4 The LEI Regulatory Oversight Com- BIC is commonly used as part of messag- Based on dozens of interviews with leading mittee is a group of public authorities from around the globe established to ing, which financial institutions use to industry professionals and experts, as well coordinate and oversee a worldwide framework of legal entity identifica- communicate, and is also used in SWIFT’s as secondary research on existing, LEI-en- tion, the Global LEI System: http:// KYC utility. abled processes, we can state that there are www.leiroc.org/. The Legal Entity Identifier: The Value of the Unique Counterparty ID 23

multiple use cases beyond the three identified achieving the network effect within industry in this paper. Operational efficiencies, cost subgroups. This effect can begin with further savings, reduction of time to transact with discussion among beneficiaries and other clients, and more reliable information can stakeholders. As new use cases for the LEI be gained by introducing the LEI into almost take hold and companies and the banking any process that requires identification and institutions financing their activities work verification of a counterparty and that has a with each other to encourage the adoption manual component. of the LEI, the benefits and business value described above will grow, and easier coun- For companies of varying sizes across dif- terparty identification will open the door to ferent industries, the LEI can enable cost further automation and digitization of fi- savings, expedited payments, and improved nancial and commercial transactions around customer experience. While the value of LEI the globe. use is clear, the adoption of LEIs depends on 24 The Legal Entity Identifier: The Value of the Unique Counterparty ID

Contact For more information, please contact:

Philip Bruno Stephan Wolf Partner Chief Executive Officer [email protected] [email protected]

Gabriela Skouloudi Meral Ruesing Associate Partner Head of Communications [email protected] [email protected]

Haris Usman [email protected] Consultant [email protected]

McKinsey would like to acknowledge the contributions of Andrea Stefanucci, Francesco Abate, and Thomas Doutre to this report.

October 2017