Network externality

Managing Risk and Complexity: Legal Entity Identifier

Prior to the financial crisis, even an informed observer might have naïvely believed that the CEOs of big financial firms could simply push a button to view the current exposure of their firms to any other firms in the world. Or, if less technologically advanced, they could call their chief risk officers or chief financial officers to obtain end-of-day positions.

Not even close. By the time that Lehman failed in September 2008, large financial holding companies had evolved into extremely complex structures with hundreds or thousands of subsidiaries for which the parent companies lacked consolidated information technology and risk-management systems. The multiplicity of information systems meant that different parts of the same firm employed varying names and codes to identify the same counterparty. Fixing this, merging all of the information structures and ensuring consistency, would have been an expensive proposition that managers (compensated out of current profits) had incentive to delay.

Correcting these deficiencies in the financial infrastructure is not a trivial matter. Simplifying the problem requires the creation of a unique, universal, and permanent identification system for both institutions (financial and nonfinancial) and instruments. Realizing the nature of the opportunity and the challenge, in November 2011, the G20 called for the creation of a global legal entity identifier (LEI). Importantly, everyone realized that given the massive size of the financial system that supports both domestic and cross-border activity, the solution had to be global. (For pioneering analyses, see work by the Federal Reserve and the Office of Financial Research. For up-to-date information on the LEI, see here.)....

 

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Modernizing the U.S. Payments System: Faster, Cheaper, and more Secure

When it comes to domestic payments, the U.S. financial system still lags the efficiency in several advanced economies. The reasons are easy to find. First, other countries have leapfrogged outdated technologies. In the United States, checks remained dominant well after their technological sell-by date partly as a result of government support. The other key factor delaying a shift to alternative payment mechanisms is the importance of what economists call a network externality. That is, the more people who use one form of payment, the more valuable that method is to the people who are already using it. And, by the same token, the more expensive it is for someone to move away from the prevailing mechanism.

With these considerations in mind, two years ago the Fed convened the Faster Payments Task Force (FPTF), a group of more than 300 experts and interested parties from a wide range of backgrounds with the objective to “identify and evaluate alternative approaches for implementing safe, ubiquitous, faster payments capabilities in the United States.” Earlier this month, the FPTF issued its second and final report, which contains a set of 10 recommendations for making the payments system faster, cheaper and more secure....

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