A large proportion of the buy side is falling short with regards to its internal pricing capabilities, according to a research paper by Bank of New York Mellon, with nearly 40% of the respondents to its recently conducted survey indicating that they have no in-house capabilities and are relying on counterparty valuations alone for the more complex instruments in their portfolios. Respondents to the survey, which include asset managers, insurance companies and pension funds active in the derivatives markets, indicated that the challenges associated with the valuation of OTC derivatives instruments have also held back their growth in these markets.
The report notes: “While many larger or specialised buy side institutions have put in place the internal processes and systems necessary to value their OTC derivatives positions, many other institutions are forced to rely on costly third party pricing provision or restrict the scope of their OTC activities to relatively vanilla products, for which prices may be readily derived or sourced.”
The results are based on a survey of buy side institutions in the US and Europe, and it was carried out between July and October last year. All of the respondent firms indicated that despite an initial post-crisis contraction in OTC derivatives activities, they have experienced a growth in the volume and value of OTC trades over the last few years. This, in turn, has put pressure on their valuations teams and has resulted in system and process workarounds being put in place in order to keep pace with the front office.
“Just over 60% of institutions in the survey group maintain an independent internal pricing capability,” says the report. “In some cases, particularly for larger or specialist asset managers, pricing teams use internal models to price their positions. In a few cases, internal pricing teams are capable of pricing all instruments in which the institution is active. Many pricing teams perform pricing for vanilla instruments internally, and source independent prices from market data vendors or from the market, particularly for relatively standardised FX forward contracts and credit default swaps (CDS). In general, pricing teams validate their valuations by comparison with those provided by their counterparties. In less than 10% of cases, the counterparty provides all valuations to the asset manager’s pricing team.”
The standardised end of the spectrum is therefore less of a worry, but the same cannot be said of the more complex derivatives. This dependence on counterparty valuations within these markets is highlighted by the report as a key failing that must be addressed by the establishment of internal pricing teams to provide independent pricing capabilities and an increase in the use of third party independent valuations. The need to align OTC derivatives pricing with the fund valuation cycle was also cited by several participants as particularly challenging.
One option to avoid some of these internal challenges has also been to outsource these operations to a third party provider; obviously this is where firms like BNY Mellon are pitching their service offerings. “Approximately 33% of the survey group has outsourced all or part of core accounting operations to third party asset servicing providers. In many cases, these providers also provide valuation, reconciliation and collateral management services,” indicates the report.
The majority of the respondents therefore have decided to keep these operations in-house and the report highlights the predominance of tactical builds and manual workarounds to this end. The report suggests, however, that the standardisation of the OTC markets may potentially make the lives of outsourcers much easier and make the outsourcing option more appealing: “As contracts, documentation and processes converge, the incremental value from retaining accounting processes in-house may erode.”
Regulatory developments will continue to compel change in the valuations space, along with business drivers such as better counterparty risk and collateral management. The BNY Mellon report indicates that robust and independent pricing is a core element of an effective counterparty risk management process and highlights that both UCITS III and IV specifically require the managers of these funds to perform daily independent valuation of their OTC derivatives positions.
It is interesting to compare this report to A-Team Group’s European buy side research into the use of valuations providers from last year, which indicates that the take up of independent third party valuations is steadily increasing. Certainly, both reports indicate that there is room for improvement with regards to firms’ use of these pricing sources and that spells good news for the vendor community going forward.
The full BNY Mellon report, which also includes data on counterparty risk measures and collateral management concerns, is available to download here.