The demand for derivatives valuation services is growing exponentially as financial institutions require independent prices to help them de-leverage their structured derivatives portfolios and comply with FAS 157 requirements. Chris Zingo, senior vice president of Americas at SuperDerivatives, explains why independent valuation is essential in providing the transparency investors demand and satisfying accounting regulations.
Q. What are the main drivers pushing financial institutions to sign on to an independent pricing provider like SuperDerivatives this year?
At SuperDerivatives, we have seen a 250% increase in demand for valuation services in the last 12 months and there are three core drivers for this trend. The first driver is regulation which generally requires financial institutions to create an effective framework around the pricing of financial products, including coverage of all ‘grey areas’ of the portfolio or pricing operation. Secondly, shareholders are driving demand for more independent valuation services because they want more transparency in the prices of products, which can only be made possibly if a firm invests in its valuation operations. And finally, the third driver is really the volatility in the marketplace today because financial institutions are concerned about their vulnerability to market risk and especially regarding the fluctuations in risk levels that occur daily.
Many of our clients, if not all of them, are implementing operational procedure designed to complying with FAS 157. And there is some confusion regarding the new accounting standards required by FAS 157. So many of our clients are focused on trying to figure out how to implement best practices associated this mandate and they are looking to the pricing providers to advise them on how to do this.
Q. How can an independent valuation provider help a firm implement best practice in line with the new accounting requirements of FAS 157?
From a pricing provider perspective, we can provide more visibility into our valuation process and explain to clients how this works in terms of how we source the data, what observable inputs we include in models to reflect the curves and in creating a value.
A high level of transparency of data and visibility is essential for complying with FAS 157 requirements. Specifically, the mandate calls for firms to be able to show they follow best practices in testing observable inputs against variable tradable market data prices (so calibration) and apply a consistent operational process across all assets. Calibration, for instance, is a large part of what we do and this is a process clients typically struggle with. In fact, completing all of the pricing procedures and related data management in accordance with FAS 157 best practice in-house would be near impossible for many financial institutions today. For our clients, our services is a real asset because most do not have the scale of operations and resources to execute the level of due diligence on valuation processing that a specialist company can do.
Q. What are financial institutions looking for in a valuation service?
First of all, clients want a pricing service that reflects where the market is. Secondly, clients are increasing demanding full visibility into the data behind the price so providers need to be able to have the transparency to show clients how they have come up with a particular value rather then just giving them a figure. Today, clients really want and need to know the valuation details such as what specific assumptions are included in specific pricing models.
Expertise is also one of the most important factors when selecting a valuation service. As I mentioned before, it’s not enough to just provide a value; it is also about helping the client with the investigation process and answering their questions. All day we get calls from clients asking for advice on a value received so having that market expertise and service support is a crucial part of our overall offering.
Q. What about product coverage?
Generally, clients increasingly want breadth in terms of global markets coverage, but also depth as in coverage of underlying assets. The specific needs vary greatly by client.
Obviously with the market de-leveraging, clients aren’t so focused on new products and new structures, but they do want more coverage of asset classes and geographical coverage. For example, visibility into other markets, such as Latin America, and the ability to cover more local markets and local indices across the globe, is increasingly becoming a large part of our service offering.
Q. How do pricing services need to evolve this year to satisfy new client needs?
As I said before, it really is all about transparency now. At SuperDerivatives, we are looking to provide more transparency into the values that we produce to help our clients compare differentials of prices across counterparties to draw conclusions as to why those differentials exist and complete other functions, such as P&L attribution.
Also, streamlining front-office processing is one thing that people don’t often associate with valuation service, but much of the valuation efforts that are of a concern for our clients are the result of trading errors (data input errors). There is typically a lot of re-keying and redundancy involved in processing a trade from the front office to the back office which makes for a high rate of errors. We’ve been able to implement our front-office technology to help clients automate the trade capture and execution process and to improve the integrity of the trade data going into the back offices and for valuations. And of course, by reducing operational risk associated with front-office procedures, we also help our clients boost efficiency overall which is crucial to help them build the scale required to manage growing volumes.
Q. Financial institutions have variety of pricing providers and services to choose from today. What should a firm consider when selecting a pricing provider?
First of all, you need to make sure the values of a particular provider actually reflect where the market is. Financial institutions can easily discover the accuracy of a provider’s prices by doing a quantitative test, where the firm takes the structures and tests them against what they are seeing in the market by comparing the price to other sources or counterparties. Many of our clients do this test.
A second area to review is a vendor’s scale of operations. A firm should ask if the service provider in question if they can handle the volumes requested. And, more importantly, a firm should check that the vendor can accommodate certain kinds of delivery the client would demand. A mutual fund company for example, would want to know if the pricing provider can deliver all the prices, complete with comprehensive values of the underlying data, by 4:30pm daily so the firm can complete its own internal verification and related processes by 6pm.
Q. What differentiates pricing providers from one another?
What differentiates SuperDerivatives from our competitors is summed up by three words – data, model and calibration. Prices are only as good inputs used to include in the model, and the model is only useful when compared to the market via calibration.
Providers are not created equal. Some are pure modelers or really only redistribute prices they gather from multiple sources. But really, in the OTC derivatives market place, you need to be actively testing your data and models and expanding your methodologies and data model to come up with the best and accurate product prices.
Q. What is a surprising or unexpected benefit from using an independent valuations provider?
Operations and scale might not have been the original driver for signing up with a valuation provider, but I think it’s a very powerful byproduct. There are operational improvements to be had, as I mentioned before, with better integrity of trade data moving through front-end technology. Plus, this means a client can save on the cost required to invest in internal operations to support new pricing processing requirements and growing trade volumes.
Better internal OTC market expertise is another unexpected benefit. Unless a firm sees the values daily, they aren’t seeing how they are changing across assets and across products, and this is crucial in building up market knowledge. Use of an independent valuation service builds up a firm’s internal expertise of OTC derivatives market place exponentially.
*SuperDerivatives is a derivatives solution provider, providing real-time accurate pricing for all options through its unique pricing model.
