Roger Boyd, global head of Citi’s Complex Pricing Group (CPG), speaks to Reference Data Review about recent events in the market and how his firm has dealt with the complex area of valuations and counterparty pricing.
Much like the rest of the financial services community, the last couple of years have been tough for Citi. In February this year, it declared a US$8.29 billion loss for its fourth quarter 2008 results and, for the full year, it declared a loss of US$18.72 billion. These losses can, in part, be attributed to the spectre of counterparty risk.
At the release of the results, Vikram Pandit, the firm’s CEO, explained that Citi had tackled the issue of risk head on in order to reduce balance sheet losses and survive the market downturn. This endeavour has impacted all of Citi’s business lines and divisions and Pandit is now championing an overhaul of the firm’s technology infrastructure in order to reduce duplicative systems and achieve significant cost savings.
Pandit is keen to integrate previously disparate systems, of which acquisitive Citi has many, across its entire business. On the data integration side, the bank has lost previous chief data officer, John Bottega, to the Fed, but some aspects of data management remain on the to do list for this year.
Julia Sutton, Citi’s global head of customer accounts operations, briefly elaborated on the bank’s plans to introduce a centralised utility for customer data at last year’s Fima conference in London. To this end, the bank is working with Avox and Markit Document Exchange on normalising and validating its customer data and documentation, which recently resulted in the announcement of a public partnership between the two vendors.
Valuations is another area that has garnered the attention of senior management and Citi has been working towards achieving more transparency in its valuations offering, says Boyd. “Citi is constantly working with OTC valuation providers to increase the number of instruments independently able to be priced. In the instance where a client trades a new instrument that is not currently independently able to be priced by a vendor, we will work with all parties to see if a new valuation model can be developed,” he explains.
Examples of this work include checking both the integrity of the data used by valuation providers and the acceptability of the models used by such companies chosen to provide independent valuation. “It has been instrumental in improving the independent valuation processes on a number of occasions,” he contends.
“In one instance, the team questioned the recovery rate assumptions used by a fund client for a particular credit default swap (CDS). A market default recovery rate of 40% was being used as a standard, but this element of a CDS valuation is dynamic and pricing should reflect market conditions. An exploratory conversation with the client resulted in a change to their valuation process when the CPG was able to highlight potential weaknesses in their approach,” he elaborates.
In another situation, Citi’s CPG team improved a valuation vendor’s approach to pricing a long dated equity variance swap – essentially a bet on market volatility, continues Boyd. “Finally, one of our largest investment management clients had taken out a 10 year equity variance swap and the instrument was proving very difficult to value due to the absence of pertinent market data. In his instance, the vendor was providing daily quotes from monthly observations of volatility. Following a discussion with the vendor and the client, it was agreed that such observations would not be acceptable. Citi’s CPG independently reverse engineered the vendor price, highlighting the root of the price challenge to the client and valuation agent. This resulted in the vendor agreeing to make more frequent volatility observations, resulting in a more accurate valuation.”
Boyd reckons that Citi has long led the way in the provision of independent valuations for OTC derivatives and hard to price securities. The CPG was set up in 2003 as a response to the growing number of client traded credit derivatives with a view to providing its fund accounting clients with an extra layer of risk management, he explains.
He is confident that the capabilities of the team are a match to the requirements of the industry: “Made up of dedicated analysts with experience in finance, economics and mathematics, the team has the ability to reverse engineer OTC derivatives by drilling down into the underlying structure to question or validate its pricing. The CPG services Citi’s clients around the world by pricing complex funds, dealing with more than 20,000 OTC positions. Valuations are provided on a monthly, weekly or daily basis.”
The group sources data from a range of independent valuation providers, using scrubbed prices in order to ensure deep and transparent coverage. Those prices are then compared with secondary pricing sources, such as those from an investment manager. Where differences exceed pre-determined tolerance levels, an analyst reviews the underlying market data and valuation model to determine the root of any price challenge.
In the instance of a price challenge, the skill set of a derivatives specialist is essential to performing a ‘deep dive’ analysis and providing an objective and informed view, says Boyd. Moreover, there are certain complex derivatives, such as correlation swaps or equity variance swaps, where the CPG can have access to more data than the client.
“With access to a full range of forward curves, volatility surfaces and currency pairs, the team can independently value a position or reverse engineer a valuation, decomposing an instrument into its constituent parts,” he explains. “Importantly, and above all else, the client has somebody that speaks their own language while end investors know that their fund does not have to rely on just counterparty prices.”
The fall of financial institutions such as Lehman Brothers last year has underlined the importance of transparent pricing and independence in this space. “Commentators note that the practice of marking to market for complex OTC derivatives has sometimes been ‘marking to myth’. As such, investors are increasingly wary of pricing that only relies on counterparties. For hedge funds keen to retain the confidence of investors, it has never been more important to demonstrate transparency in the valuation of OTC instruments,” concludes Boyd.
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