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Valuation Function in Need of Repair to Increase Transparency, Says Celent

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Firms and solution providers involved in the valuation function need to go back to the drawing board to revisit the often piecemeal approach to pricing, according to a recent report by analyst firm Celent. The current market conditions have heightened the need for transparency and firms must now re-evaluate their valuation solutions to make sure they are fit for purpose, explains Cubillas Ding, author of the report and senior analyst at the firm.

The report, ‘Pricing Solutions for OTC Derivatives and Structured Products’, highlights the need for procedural consistency in financial institutions’ complex deal pricing and portfolio valuation activities. “In many firms, pricing or valuation activities are done using spreadsheets, which may not be fit for such purposes and are prone to error,” explains Ding.

“The analytics used to build models are often fragmented. Additionally, after the deal is agreed and captured, the position keeping, P&L reporting and risk management of these deals need to be done in other systems. These systems require the means to incorporate model-based price information, but analytics and models do not lend themselves to being easily ported between various downstream systems, such as those used for limits management, position keeping, collateral management, and market or portfolio risk measurement. Additionally, the model governance aspects leave a lot to be desired because of the many touch points for which models are employed,” he continues.
The moves towards financial reform in the markets as a whole are indicative of the increased level of scrutiny of areas such as valuations, according to the report. Regulators, investor groups, quasi-governmental organisations and government agencies are driving towards an emphasis on having well defined processes and ensuring that these processes are repeatable. Industry reform is already on the way, but the full fallout has not yet occurred, warns Celent.

Ding identifies what he believes the impact of this scrutiny to have been thus far on the market: “Overall, the mantra of transparency, independence, and accountability has not gone away – instead, over the crisis period with liquidity and mortgage backed assets becoming distressed and markets frozen, it has gained increased resonance. The emphasis here is for well defined pricing and valuation processes that are repeatable, not just a one-off activity in a ‘black box’.”

This has resulted in a significant impact on the solutions available from the vendor community, says Ding. In general, more intense scrutiny of pricing practices by other groups beyond the front office quants – for example, product control, risk and audit functions – is driving requirements for non-quants to be able to re-price and verify deal information, assumptions and price outputs without necessarily requiring low level IT or programming skills to achieve these tasks, he contends. “Additionally, transparency into pricing models has already become paramount – with pricing library components, add-ins, and toolkits needing to open the structure and make it transparent, assumptions, and model mechanics,” he adds.

An increased thrust to monitor risk exposures of complex products has led to efforts to align front end pricing mechanisms and control functions with middle and back office accounting and risk management applications, according to Ding. “These encompass various aspects involving organisational and procedural alignment, but from a technology perspective, it often translates to a greater need for front to back model consistency. Increasingly, firms put an emphasis on integration frameworks, ease of integration, or having pricing solutions incorporate ‘out of the box’ interfaces with existing third party components, like with market data sources, front office trading or risk systems and enterprise portfolio risk management applications,” he explains.

“Moreover, the loss of personnel as a result of the credit crisis means that financial firms often lack the internal expertise to accomplish ongoing pricing of these assets,” he continues. “In many instances, this also translates into a higher propensity to engage third parties, given lack of internal expertise and loss of financial engineering personnel. Despite the pricing analytics vendor market being filled with niche players, firms that can adopt a solution focus (beyond merely analytics) have gained traction through the crisis period so far.”

The report examines the relative market position of eight vendors in the current market: Numerix, Quantifi, Fincad, Pricing Partners, SunGard Reech, UnRisk, Andrew Kalotay and SciComp. These vendors are evaluated across four categories: advanced technology; breadth of features and usability; customer base; and depth of financial institution services.

In terms of advanced features and technology, the report identifies Numerix, Quantifi, and Fincad as “leading vendors”. In particular, it indicates that Numerix and Quantifi have demonstrated a strong track record of staying at the “cutting edge” of pricing complex securities and building out scalable valuation applications. Celent contends that both have shown specific evidence of participating in financial crisis response industry initiatives and helping firms untangle the fallout related to the pricing of distressed assets.

According to Celent, Fincad in particular has continued to strengthen its analytics across multiple asset classes and now has enhanced capabilities to support cross asset pricing for structured products. “Its next generation Foundation Framework analytics and applications are expected to support higher ease of use, stronger integration capabilities, technical flexibility and high performance computing,” states the report.

In terms of functional breadth and asset coverage, the analyst firm’s report contends that the vendors that fare well have a mixed asset class approach and other mechanisms to “distribute” their analytics. It therefore places Numerix, Fincad, Pricing Partners and SunGard Reech into this category.

“Numerix and Fincad particularly stand out not only in terms of having a broad asset class coverage for their pricing libraries, but also significant independent software vendor (ISV) partners that embed their models and tools in their applications, therefore enabling clients to gain more consistent access to their models in third party applications,” says the report.

It judges that Numerix is strongest in going to market with a wide set of applications built using their analytics libraries and, in many instances, developed in conjunction with partners in other parts of the order management, trading and risk management solution chain.
Overall, Fincad and Numerix by far have the highest number of clients in their portfolio compared to their peers, each with more than 300 clients, as a result of partnership agreements, says Celent. “Fincad and Numerix have demonstrated a sustained vigour to partner with vendors in the different parts of the value chain – securing formalised relationships with market data, portfolio risk management, order management systems (OMS) and trading vendors,” it says.

Celent contends that both firms have a much larger network of partners compared to their peers, with Fincad leaning towards buy side vendors and Numerix with sell side ISVs in general. In addition to Fincad and Numerix, the report highlights Quantifi and SunGard Reech as having demonstrated a good track record in terms of volume of clients, client tiers and quality of clients. “For this category, although Pricing Partners and UnRisk have momentum in terms of client wins, their successes have still primarily been in their respective home countries, France and Austria (and German speaking jurisdictions), and not yet beyond,” the report states.

In the depth of client services dimension, Numerix is singled out again because of its expanded product functionality and services footprint into various parts of the structuring and OTC lifecycle. It is also credited for customising its product offerings to cater to users within asset class groups. “Since the credit crisis mid-2007, Numerix has been actively engaged in a higher degree of advisory type services around alternative valuation techniques (for example, for distressed assets), implementation of its position keeping application and participation in industry dialogues with regards to pricing or valuation practices,” the report contends.

“Overall, established players like Numerix and Fincad have a global view of client’s needs and operate across multiple instrument classes (although each still have their own asset class sweet spots). In addition to this, Fincad and Quantifi in particular have been given favourable client opinions in terms of implementation, service and support. Fincad in particular caters to a diverse set of end users, which include banks, corporations, software providers, asset managers, hedge funds, custodians, auditors and other professional services firms,” says the report.

In the longer term, Ding anticipates that vendors will be required to up their game even further, as more firms with multi-asset class pricing requirements will rationalise fragmented models or pricing tools and will emphasise solutions that cover a broader range of asset classes. “The merits in leveraging a single analytics framework and standard libraries across line of businesses are certainly worth exploring – cost effectiveness, skill synergies, and time to market for new product deployment. Early indications seem to point towards this leaning among forward thinking organisations,” he concludes.

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