OTC markets: Increasing transparency in the valuation process

15 December 2011

By Anthony Belcher,
director,
EMEA Valuations,
Interactive Data

In the post-crisis world there has been a much greater demand for information in the financial markets. Clients, auditors and regulators are seeking a holistic view and are calling for more openness and insight into the investment activity of financial firms. The need for greater transparency and risk mitigation in the valuation process has become critical, especially when it comes to over-the-counter (OTC) markets. Under such increased scrutiny, investment firms have had to re-think how they price certain assets, appraise the value of their holdings and associated risk exposure.

Clients now demand that the valuation process and workflow provide a level of transparency to better understand the underlying methodology of an evaluated price or how a net asset value (NAV) is calculated. Auditors also look for transparency around the evidence used to support a valuation. They need to understand how the valuation fits into regulatory principles and meets the demands of new accounting standards. The regulators themselves need to understand the risk-weighted appetite for non-equity instruments, as well as the many more stress-testing scenarios that require underlying valuation assumptions.

Valuation approaches

When pricing instruments many investment firms use a combination of approaches, as well as multiple sources. Approaches might include proprietary valuation methodologies, broker or counterparty pricing, and increasingly, independent evaluated pricing.

Each approach can have its advantages and disadvantages, often depending upon the coverage required and level of liquidity involved. Broker or counterparty prices can be fast and inexpensive for those who have access, but lack transparency and consistency and carry a potential conflict of interest. Coverage is often limited and internal processing is required. Composite pricing uses a wider market and is good for liquid instruments, but prices can be distorted and the method falls short when it comes to less liquid instruments. The black box model provides explainable methodology and independence, but prices can be distorted and the approach is inflexible. It is also less reliable in thinly-traded areas and lacks transparency in the valuation itself.

An evaluated price is an opinion of value based on modelling techniques and information from an extensive range of market sources. Evaluated pricing has now become a key component of an investment firm’s valuation process, offering transparency, independence and the flexibility to deal with distortions in the market. It can help firms meet their fair value requirements, address the demands of risk and portfolio management, and comply with existing and new regulations and accounting standards. However, evaluated pricing takes more time to create. Best practice calls for global teams of highly qualified analysts or evaluators, who detect and reflect in-depth, local knowledge and current market activity using an extensive network of contacts. They analyse the various characteristics of complex instruments and combine available inputs to create an objective, good faith evaluation as to what a buyer in the marketplace would pay for the instrument in a current, non-distressed sale. Scale and quality of resource is important in this context as evaluators need to react to market changes, which is even more crucial in times of increased volatility.

Seeing behind an evaluated price

Investment firms need to clearly see - and be able to show - up-to-date inputs to the range of market data used, including corporate actions and reference data such as terms and conditions, benchmark curves, risk adjustments, ratings information, and other relevant industry and economic events. Firms also need to understand the assumptions made and the analytics included in the evaluation process. When using third-party providers, it is essential to work with them to understand their methodology: their approach and process used to combine all the inputs and assumptions. In this way an investment firm can benefit from a more efficient valuation process, help mitigate operational risk and better manage costs.

Post-Lehman, the increase in volatility and wider bid-ask spreads for certain asset classes led to an increase in client price challenges. The ability to challenge a valuation, if queries arise concerning the underlying information, can provide additional transparency into a firm’s workflow processes. Web-based, self-serve tools are now available to log single or multiple challenges and review the up-to-date progress of those challenges throughout their lifecycle. Such tools enable firms to demonstrate to auditors and compliance teams a centralised process, audit trail and management reports, helping to add transparency to the overall valuation procedure.

Applying context to evaluated pricing

In addition, new web-based applications can now offer firms the ability to visualise evaluated prices within the context of an extensive range of relevant market information, including public and proprietary market data inputs used in the evaluation process. In the diagram below, the inputs, assumptions and market colour appear side-by-side with evaluated prices in a single intuitive display. Such initiatives can offer users increased transparency, timeliness of market information and improved operational efficiency through automated end-to-end back office solutions, which include audit trails and can be adapted to a firm’s own workflow. As information flows increase exponentially it is important to have ways to review and act upon market information that does not overwhelm the user.

Introducing Vantage

Source: Interactive Data’s VantageSM

Impact of regulation and accounting rules on transparency requirements

New regulations, directives and accounting standards are particularly impacting transparency requirements in valuation processes on both the buy and sell side.

MiFID II

Proposed MiFID II reforms include the need for increased transparency in pre- and post-trade reporting and would embrace non-equity products. The proposals for pre-trade transparency require both quotes and depth of quotes from all trading platforms to be made public, while the proposals for post-trade transparency require all trades to be made public as close to real time as possible. National regulators will be able to set waivers to exempt some transactions or decide when trades are eligible for delayed publication, although the European Securities and Markets Authority (ESMA) would then have the ability to pass judgement on the compatibility of the waiver relative to overall MiFID legal requirements. Once adopted, MiFID II reforms should provide additional information and colour in support of the evaluation process.

AIFMD and InvRBV Directive

Also in Europe, the Alternative Investment Fund Managers Directive (AIFMD), which came into force on 21 July 2011, requires the use of independent valuations with transparent and open processes. EU member states will need to transpose the directive into their national laws by 22 July 2013. In Germany, the Investment Fund Accounting and Valuation Directive (Investment-Rechnungslegungs- und Bewertungsverordnung - InvRBV), ratified in December 2010, also requires increased transparency and reliability of processes for valuing financial instruments and of process documentation.

OTC derivatives market

New regulations are also being introduced to oversee and increase transparency in the OTC derivatives market. The Dodd-Frank Wall Street Reform and Consumer Protection Act and the European Market Infrastructure Regulation (EMIR) aim to centralise derivatives trades in the clearing houses that have long provided a form of safety net for other types of trade around the world, while under UCITS IV, asset managers investing in OTC derivatives within a UCITS fund structure must now source independent valuations to meet the demands of regulators. At a global level, the G20 aims to prioritise transparency in order to reduce systemic risk and to improve the regulation and supervision of exchange-traded, OTC derivative and physical commodity markets.

IASB/FASB

New accounting standards will also increase the amount of transparency available to investors. Greater depth of information around the inputs and approaches that are used to create valuations is essential for meeting the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) requirements. Under the fair value hierarchy, valuations for each class of instrument is categorised under one of three levels and more detailed disclosures are required for those instruments measured under valuation techniques that rely heavily on unobservable data. Adjusting procedures to comply with new fair value requirements is an important change for firms in the valuation space.

An all-round understanding

Continued volatility in the global financial markets underscores the need for higher levels of transparency in the valuation process. Firms are determined to better understand the context of a valuation, including the underlying market data, the approach and modelling techniques, and the calibration strategies. Throughout the industry, investors, risk managers, auditors and regulators all expect consistent, transparent and fair pricing across the range of OTC instruments, especially at the less liquid end of the market. Best practice calls for sound and transparent valuation procedures that can enhance a firm’s risk management and compliance operations, but more importantly, help restore the confidence of their investors.

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