Mukta Rani, 1273580, F1, Q-50

Regulation need to drive transparency and simplification of products and services? Comment.

Pricing for OTC derivatives has been a significant challenge for financial institutions since the day these instrument types first began trading. With the vast array of regulatory mandates for the financial markets under consideration in the United States and Europe, trying to understand and reconcile the nuances between them is adding to this challenge.

The sheer volume of rule making in the U.S. is compounded by the fact that, in many cases, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are advancing separate rules, that while similar in substance, have nuanced differences given the types of instruments that each agency is responsible for overseeing. With the introduction of European Markets Infrastructure Regulation (EMIR) there is no doubt that the combination of these regulations on both sides of the Atlantic will result in what were previously opaque OTC markets becoming far more transparent.

However, these rules are also creating a unique paradox. While they will facilitate access to trade-centric information, the wealth of new information poses as much potential to complicate the valuation activities of financial firms as help them.

The following describes some of the challenges resulting from this new landscape.

Many Derivatives Are Thinly Traded
One dynamic easily lost in the euphoric headlines ushering in a new era of transparency for OTC derivatives is that certain types of derivatives are, and will likely continue to be, illiquid. For example, last year, the Federal Reserve Bank of New York reported eye-opening statistics about the lack of trading in single-name credit default swaps (CDS) – the U.S. corporate bond marketplace outpaces the global volume of daily trading in single-name CDS by five times. The most actively traded CDS names traded only 10 times per day on average. Less actively traded entities traded only four times per day, while the largest category by far, the infrequently traded entities, traded on average less than one time per day.

Consequently, while publicly reported trade data will be an important and necessary input to a derivative’s valuation, the relative dearth of trading activity on any given day is likely to require the use of methodologies and models that incorporate additional inputs. Most firms will likely need to continue investing in their valuation processes, taking into account multiple inputs including, but not limited to, information such as dealer data (broader market colour and specific quotes), curves from leading interdealer brokers, reference rates and related trading activity from cash bond markets (in part, because the bond markets are more liquid).

Aggregating Publicly Available Trade Data for Reporting
The “real-time” reporting of derivatives transactions is one mandate that is prone to creating additional challenges for firms seeking to incorporate such data into their valuation processes. For example, the discrete fields that will be required for counterparties to report transactions to swaps data repositories vary from agency to agency, and the various regulators may use different terminology for the same data.

Beyond synthesising these details, there are also different timing requirements for reporting trade data, including delays on the reporting of block trades for example. Further complicating matters is the fact that some U.S. rules do not specifically provide for the recognition of non-U.S. trade repositories. In addition, the use of entity identifiers remains inconsistent; most dealers use their own proprietary IDs. While there is hope that the Legal Entity Identifier (LEI) initiative will alleviate this issue, gaining the global consensus necessary to implement this initiative is taking much longer than initially expected.

Consequently, it could require significant near-term investment to reconcile different IDs for the same entity if firms utilise multiple swap execution facilities, or aggregate publicly available trade information across multiple repositories, each with their own terminology, reporting requirements and timing idiosyncrasies. Given the lack of liquidity cited above, how will that investment be justified?

Pricing from Clearing Agencies
Another potential valuation issue for firms to navigate involves the role of clearing agencies, which will be tasked with, among other things, providing pricing and valuation information to help set margin requirements. In recognition of the illiquid nature of some of these instruments, it is appropriate to analyse what the valuation data provided by a clearing agency represents.

In this context, derivative valuations from an independent source unaffiliated with the clearing process may continue to be a valuable input. More specifically, having access to independent valuations – and the key inputs used to produce them – can help firms compare against required initial margins and changes to those margin requirements over time. With that additional insight, a firm can better evaluate its relationships with various clearing agencies and determine if capital has been committed efficiently.

In addition to the quality of the data provided by clearing agencies who perform central counterparty services, is the issue of when clearing agencies will deliver this pricing and valuation data to their counterparties. The timeliness of valuations from clearing agencies is an important issue, and while some asset managers and hedge funds may be indifferent to when they receive this data, other firms may have more stringent requirements. For example, a mutual fund, which has an obligation to calculate and publish a daily net asset value (NAV), could be subject to significant operational risk by reconfiguring its valuation processes to rely solely, or even primarily, on a clearing agency’s pricing data.

As a non-core activity for these agencies, it’s unclear if they will be able to provide valuations that meet the current standards for processes, controls and transparency that buy-side firms are accustomed to. Buy-side firms may need to undertake significant due-diligence efforts to understand if this information can meet its requirements for reliable financial reporting.
Independent Sources of Pricing and Valuation Data

The independence of third-party firms providing valuation information may well become an increasingly sensitive issue. On both sides of the Atlantic, antitrust investigations were launched related to the roles that a number of major banks and other firms played in the credit derivatives clearing, trading and information services industries.

With that as a backdrop, regulators have called for improved disclosure related to conflicts of interest. However, these requirements typically do not yet extend to relationships with third-party valuation firms. Firms should understand the affiliations that may exist between their third-party pricing services and clearing agencies, dealers and other counterparties.

Audit and Regulator Scrutiny of Valuations

Regulators and auditors have already begun subjecting the valuation process to greater scrutiny. For example, comments from the staff of the SEC and the Public Company Accounting Oversight Board (PCAOB) indicate an increased focus on the determination of fair value measurements used in financial reporting, particularly when valuations from third-party sources (including clearing agencies) are utilized. In this context, audit procedures will continue to evolve in ways that emphasize that the preparer of financial statements is responsible for the valuation process and for understanding the techniques, inputs and assumptions behind third party valuations. Firms may need to re-examine their valuation processes in place in order to document and catalogue key inputs and methodologies used to support their derivative valuations.