In the post-credit crisis world, firms must develop a joint approach to OTC derivatives pricing functions across their internal departmental silos, according to a recent report by consultancy firm Celent. In order to increase the transparency of valuations and meet regulatory requirements to this end, financial institutions must adopt coherent and consistent pricing strategies, says Cubillas Ding, author of the report and senior analyst at the firm.
The report, OTC Derivatives and Structured Product Pricing Practices: Trends and Technology Strategies for the Coming Market Reformation, indicates that transparency was a key trend for valuations even before the financial crisis. “In a post-crisis period of financial reform, and with a substantial pool of complex securitised assets and structured products, we are now seeing unprecedented levels of scrutiny and requirements for firms to show procedural consistency in their complex deal pricing and portfolio valuation activities,” says the report.
This has meant that there is a push towards greater transparency, independence, and accountability by all financial market participants via the implementation of standards in the valuations process. Celent therefore advises these firms to move towards a federated “publish and subscribe” organisational model for pricing functions. This essentially means the implementation of common practices across the firm with a horizontal approach to valuations. Ding stresses that this is especially important for middle and back office functions such as accounting, collateral management and risk measurement.
These firms should also be engaged in improving the consistency of pricing analytics across the trade lifecycle to achieve what Ding calls “straight through pricing practices”. The pricing practices must therefore be consistent across all stages of the front to back office value chain, which Celent claims will reduce operational risks associated with model inconsistencies. “The best practice is to drive analytics consistency, standardisation and interoperability across the lifecycle of an OTC or structured deal,” the report states.
The definition of a coherent strategy for a model development infrastructure is another key recommendation in the Celent report. “Financial institutions should recognise that the data environment for modelling is more complex relative than a typical application environment due to the high degree of data quality required. In order to support transparency and integrity of the model development process, firms should design/implement procedures and mechanisms for data quality and change control into the data and model development environments upfront, rather than retrospectively,” the report recommends.
Firms must also align front office, risk control and support interactions based on derivative product lifecycle dynamics, according to Ding. This can be achieved via the adoption of distinct technology strategies and organisational models for new and more complex derivatives, says the report. This is in contrast to a one size fits all approach, which the firm argues is not appropriate for the more complex end of the spectrum. These strategies and models are especially important for control functions such as: “An ability to articulate a clear and consistent control framework, to adopt a balanced trade-off in consolidating position keeping repositories, and to aggressively automate the information supply chain in product control processes, for example, P&L production.”
Transparency needs to start from the beginning of the cycle, so upstream processes must increase the visibility of the “ingredients” that go into the production of valuations, argues the consultancy firm. This transparency around the key information requirements of control functions will have an impact downstream and reduce the risk of mis-marking incidents, says Ding.
Celent champions the use of a “top down” approach to valuations architecture: “In the current distressed market, forward thinking financial institutions are again taking a fresh, top down view of how to create a ‘federation of production processes’ and, when possible, to leverage offshore resources to reduce costs and increase productivity.” This essentially entails an entire business process chain approach to architecture and knowledge related processes in which scalability across an organisation is important. The “building blocks” must be carefully considered for such a model and future requirements are also something that must be included.
The report highlights that despite the crisis, OTC derivatives are still growing as an asset class: the notional amounts of all OTC contracts stood at US$683.7 trillion at the end of June 2008. The firm reckons the increase is being driven by the requirement to manage the volatility of the market and Europe is leading the charge with regards to structured product issuance. However, although institutional investment remains high, there is dampened appetite for retail investment in these products across all regions.
“Looking ahead, as we expect investors to increase allocation of funds to derivative-based products, structured funds and hedge funds, there will be calls for higher levels of investor assurance, especially in times where asset prices continue to be volatile, or in certain cases of broken markets, where observable market inputs are impaired,” the report concludes. “With pricing and valuation practices standing at the heart of future reforms, all firms participating in listed, OTC derivatives and structured instrument markets need to develop a coherent strategy for executing derivatives pricing, risk management and product control with a higher degree of transparency, independence and accountability.”