Interactive Data’s Anthony Belcher explains why firms shouldn’t rely solely on the CCP price and how better transparency will mean better dispute management.
As CCP clearing deadlines loom, many buy-side firms are grappling with the new mechanics of central clearing workflow, including CCP pricing. Buy-side firms require clarity on the models clearinghouses will use to price cleared derivatives and also how these prices will be provided to the clearing brokers and then onto their clients. There are many points in this chain, which creates complexity and the potential for errors. At worst, mis-pricing can negatively impact margin requirements, even instigating disputes, which must be resolved in a tight timeframe. Buy-side firms have the opportunity to prevent possible operational headaches by tackling this issue internally, with its clearing brokers and third-party pricing providers ahead of moving to CCP clearing.
The risks of relying solely on the CCP price
Many institutions have uncertainty over how the CCPs will be arriving at their pricing and what their pricing procedures are, which will impact how they manage collateral and risk. Clarity from the clearinghouses on their methodologies is needed, but most buy-side firms will not rely solely on the CCP price. Best practice suggests that the CCP price shouldn’t be the only input, but one of many that firms should be checking against internal models, and evaluations provided by third party valuation providers.
Despite a lack of clarity on the specifics of CCP pricing models, firms need to take the time now to make sure they have got those processes in place so they are able to do comparisons between the CCP price against their own prices – even if they haven’t had the chance to build out their internal models and systems. It doesn’t take long to source an alternative price to do a side-by-side comparison for those trades, either the trade itself or the collateral that underlies it.
Some providers, such as Interactive Data, provide workflow tools for those eager to avoid the expenditure of IT resources on developing internal models. Generally, such tools can be offered alongside the third party’s evaluations.
Dive deeper into methodologies; including those of vendors
Transparency is key when assessing prices, especially those supplied by third parties including the CCP and pricing vendors. It is important to understand the inputs into the pricing, the methodologies and assumptions used to create the price and then to assess whether that methodology is consistent with the firm’s needs.
Firms should focus on their overall review procedures rather than just the inputs. They need to ensure they have sophisticated control mechanisms to be able to understand and identify potential issues rather than a flood of information about changes in price. For example, if the whole market moves up five percent, looking at every single security that has moved up five percent isn’t inherently useful. Instead the firm may want to focus on movements contrary to the trend, for example by focusing its review on securities that haven’t moved up five percent.
From a technological standpoint, many firms still use spreadsheets as part of their controls, but with that manual approach there are inherent risks. There may be regulatory or accounting requirements to demonstrate that they have proper controls in place. Automation in some capacity can help demonstrate the sufficiency of controls, while also reducing manual errors and operational risk.
Better price transparency, better dispute management
Another issue surrounds the management of disputes on the valuations for both the derivative transaction and the collateral that underlies that transaction. Any amendments or adjustments to the valuation of the derivative will require amendments to the amount of collateral that is held. And as the value of the collateral has moved at the same time as the value of the derivative, this compounds any differences in valuation on required collateral. These disputes can cost management time and result in inefficient use of capital, both of which are in short supply at the current time.
Pricing and dispute risks can be mitigated through the introduction of an independent third party. Clients are using our VantageSM <!– /* Font Definitions */ @font-face {font-family:Calibri; panose-1:2 15 5 2 2 2 4 3 2 4; mso-font-charset:0; mso-generic-font-family:auto; mso-font-pitch:variable; mso-font-signature:3 0 0 0 1 0;} @font-face {font-family:Cambria; panose-1:2 4 5 3 5 4 6 3 2 4; mso-font-charset:0; mso-generic-font-family:auto; mso-font-pitch:variable; mso-font-signature:3 0 0 0 1 0;} /* Style Definitions */ p.MsoNormal, li.MsoNormal, div.MsoNormal {mso-style-parent:””; margin:0cm; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:12.0pt; font-family:”Times New Roman”; mso-ascii-font-family:Cambria; mso-fareast-font-family:Cambria; mso-hansi-font-family:Cambria; mso-bidi-font-family:”Times New Roman”; mso-ansi-language:EN-US;} @page Section1 {size:612.0pt 792.0pt; margin:72.0pt 90.0pt 72.0pt 90.0pt; mso-header-margin:36.0pt; mso-footer-margin:36.0pt; mso-paper-source:0;} div.Section1 {page:Section1;} –> SM product to provide price transparency for collateral management with the goal of preventing disputes. It can be useful on a bilateral basis for clients to agree to use the same independent source as that can remove dispute issues and the costs of managing those disputes. The added transparency into a price that it affords should help to reduce the length of time it takes to deal with disputes even if they are continuing to use their own pricing models.
Benefits on liquidity and capital management
A key benefit of transparency of pricing models is the ability to reduce the rate of errors and mis-pricing of assets, which would have had an impact on collateral requirements. With capital constraints, market participants are trying to make sure that they are reducing the amount of collateral required to support these processes. Buy-side firms who have a robust and transparent pricing operation in place for cleared derivatives workflow will be better able to manage their liquidity.
Takeaways
It is clear that both buy and sell-side firms need to become more comfortable with the pricing procedures in order to prepare for the looming clearing deadlines. And the best starting point is for both parties to initiate conversations with each other to clarify the valuation chain now. Also, the CCPs will need to provide clarity on their own models and pricing procedures to explain how a price is derived and related processes around that.
This article is provided for information purposes only. Nothing herein should be construed as legal or other professional advice or be relied upon as such.
