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Credit Crunch Pushes Industry Mood in Favour of Third Party Valuations, OTC Val’s Blance Believes

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The credit crunch may have put pressure on spending decisions by financial institutions, but the need for external sources of evaluated prices, particularly for asset backed securities, has been “starkly portrayed”, and the “mood is definitely swinging in favour” of making greater use of third party sources, believes Ian Blance, who recently joined derivatives specialist OTC Valuations after many years at Interactive Data, to drive the newcomer’s business development globally.

While there may be rationalisation to come on the supply side of the valuations business, where “there have probably been a few too many smaller operations set up for all to survive”, there will also be more alliances between traditional vendors and the smaller niche providers. And anyway, he believes, “there can never be too many sources for the end user”.

OTC Valuations has signed its first clients and currently has 20 trials under way, Blance says, “so momentum is building”. “I have been brought on board to build the business globally, but specifically in Europe where much of the innovation in derivatives takes place,” he continues. “I have spent time working in the US so have contacts there, and the New York market is also huge. We see a big opportunity among the derivatives hedge funds, but we are also seeing interest from the traditional investment banks and investment managers.”

The first stage of development for OTC Valuations has been to build the valuations capability, “because we have to be able to prove to potential clients what we can do”, Blance says. “The sales process always involves a trial period of intensive testing before any kind of contractual relationship is entered into. In the fixed income world, a client might well assume that a service from a big, established provider will probably meet its needs. In the derivatives world valuations providers have to work harder to prove their capabilities,” he reckons.

He also believes it is important to differentiate between the approaches of different providers of derivatives valuations. “Issues associated with derivatives valuations are frequently bracketed together under one banner, but there are differences in the problem depending on whether the deal is complex and exotic or vanilla,” he says.

”Complex to value instruments such as CDOs and structured notes inherently require judgement calls on calibration of parameters and choice of data and require a lot of expert attention. Vanilla instruments such as many swaps, on the other hand, are not necessarily difficult to value from a quantitative perspective, but because the instrument isn’t publicly issued or doesn’t have official identifiers it is often challenging to get up to date pricing from an operational standpoint. OTC Valuations focuses on both pieces of the picture.”

OTC Valuations is not yet using any unique or proprietary data sources or models, Blance continues. “Our USP comes in the way the data gets interpreted and the models get calibrated. By using industry accepted data and methodology, and having this used in an industry standard way by our quants, we hope to most closely represent the market valuation.”

He was attracted to the Vancouver-based company for its pragmatic – as opposed to purist or theoretical – approach to valuations. “You can spend all your time in a painstaking search for the most elegant and theoretically pure model, but you could end up being too far away from the market if it is using less cutting edge, industry standard methods. I sensed OTC Valuations was on the same wavelength as me regarding taking a pragmatic approach to meet an existing demand, and I had confidence in the company’s ability to deliver workable evaluations.”

In almost every case so far, the competition OTC Valuations has faced has been an internal solution, Blance reckons. “I’m very realistic about what’s possible, and we never will completely eliminate internal solutions or counterparty pricing, but at a minimum firms need external verification to check the prices they are receiving from internal models and trading desks. There will be cases where our service will be utilised as a primary source, but there is as much opportunity in being used as a verification tool,” he says.

The biggest challenge faced by OTC Valuations specifically and the valuations industry generally is in the CDO space, he believes. “While these are complex asset types, the real problem tends to lie with the data,” he says. “This is the biggest challenge for end users as well. The problem is retaining the bespokeness of the CDO – managing not to give out enough information to make it not worth trading – while meeting the growing requirement for transparency.”

The over-riding requirement for transparency “and the ability to justify and validate pricing output” is key, Blance adds. “For a derivative value, users want to see more supporting data and the key assumptions, and this quantitative transparency tends to get delivered alongside the revaluation. In terms of the qualitative aspects of transparency – say why a particular model was chosen and what stress testing was done on it – it is rarely feasible or useful to provide these so frequently. We can provide reports outlining the qualitative information on a reasonably regular or even ad hoc basis.

All providers must respond to the needs of more demanding clients, he reckons. “Where in the past firms might have been inclined to take any number available, it is simply not possible just to deliver a number now, as clients introduce a new level of scrutiny into the evaluations world. The number needs to be verifiable and justifiable.”

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