Firms need to look beyond merely marking to market and examine the wider implications of valuation risk on their business, according to a recent report by Thomson Reuters and Aite Group. Transparency is key to this endeavour and this relates to underlying security data and embedded credit and systemic risk, as well as pricing, explains Richard Clements, global head of valuation risk at Thomson Reuters.
“The report validated the theories and beliefs held within Thomson Reuters that firms are moving in a direction to manage the overall pain points in their organisations,” says Clements. “Institutions are clearly more focused on valuation risk with an eye to systemic risk than they have ever been in the past.”
Clements reckons the industry as a whole is doing a lot of work to get ahead of the game with regard to the regulatory changes, while also preparing itself for the inevitable changes in regulation that have occurred and will continue to occur into the near future. The fact that companies are looking to increase spending on better and more sophisticated tools, shown in the near doubling of counterparty data management spending in the report, is certainly good news for the vendor community.
The report, which is entitled “Getting a Mark is no Longer Enough: Valuation Risk Goes Beyond Pricing”, focuses on feedback provided by senior managers working in valuations, risk and data management functions and their perspectives on pricing in the current market. The operation pain points being experienced by these individuals are largely centred around regulatory and risk management concerns, according to the report. There has recently been, for example, a five-fold increase in the number of price challenges as a result of market volatility and dislocation.
In the current environment it is also much harder to find adequate pricing information and both the investment and regulatory communities are asking for more data around prices: a tricky paradigm to negotiate when cost cutting is widespread. “US accounting standards are resulting in greater auditor pressure on valuation managers to demonstrate the quality of their prices. Without transparency on the source and quality of inputs supporting a security valuation, auditors are likely to push towards level three for a large number of OTC securities bringing further scrutiny and questioning from investors,” says the report.
More comprehensive risk measurements and the requirement for greater granularity of data are also having their toll on the valuation space. “Market participants are recognising the need to augment risk measurement technique with more credit and counterparty data to derive a more comprehensive view of the firm’s overall risk,” says the report. Furthermore, Basel II and accounting standards such as FAS 157 and IAS 39 are impacting the space by reinforcing the requirement for greater integrity of data.
“There have been a number of balance sheet issues that have come to light with regard to valuing level three assets,” says Clements. “The industry pressures have made significant changes to the accounting standards with FAS 157-e. However, there have also been significant discussions regarding transparency – both from the standpoint of having the ability to audit from one’s pricing source, to the discussions that the International Organisation of Securities Commissions (IOSCO) is having with regards to post-trade transparency for structured finance instruments like those imposed on the corporate bond market with Trace and the muni market with the Municipal Securities Rulemaking Board (MSRB) reporting standards.”
In order to tackle these many challenges, respondents to the survey indicated that they are focusing on improving the data environment, pricing workflow and risk management and compliance enhancements. The report suggests that the introduction of an industry utility service for hard to value securities could improve valuation accuracy of these securities with more market data concentrated in a single place, thus reducing duplication of effort and data bottlenecks.
Industry participants are also focused on validating the pricing vendors that they engage with and ensuring that they have diverse sources of pricing and evaluation. Now that the onus is on the preparer of net asset value (NAV) calculations to prove the quality or level of their price under FAS 157, the “net needs to be cast wider” to find the best source for a price, says the report.
Deeper integration of counterparty and credit data into workflow was cited as another important aspect of valuations risk, along with a review of the data management environment to identify key tactical areas of improvement and strategic shortcomings.
Clements believes firms should also take a bird’s eye view of risk in order to see the wider picture and prevent any areas being neglected. “One of the issues that must not be overlooked is the impact of individual risks from a systemic risk standpoint. For instance, if a firm is checking the risk parameters from their viewpoint, there are a number of things that are out of their control that could greatly impact the valuation of their portfolios – counterparty risk,” he explains.
“The other thing to remember is the international aspects of the markets. What started out as a US subprime issue has ballooned into a global systemic risk issue. Firms must look toward the macroeconomic implications of risk,” Clements continues.
One also must not forget that institutions make money by taking risk but, in the short term, institutions have minimised their overall risk exposures. “Taking this into account, when institutions return to a ‘normal’ risk appetite environment, they must scrutinise their risk more closely. What this means is that they will potentially have the same risk appetite as before, but they must better understand the overall assets that they are positioning,” says Clements. In other words, they may have the same risk appetite but will do better due diligence and hence not purchase the same financial instruments that they were investing in two years ago.
Accordingly, Clements recommends that these institutions must invest and continue to invest in: better valuation services and tools; better underlying data to have better transparency on the instruments that they are scrutinising; and better counterparty data so as to better understand counterparty risk. “The main challenge in this space is managing the correlation risk and interconnected risk that are all under the umbrella of valuation risk,” he says.
The vendor community has not gone unscathed during these troubled times and consolidation is likely on the cards for the future, adds Clements. “The vendor community has been hit along with everyone else. I would venture to say that there will be contraction in this space as we have seen in the financial services space,” he explains.
However, Clements is confident that firms like Thomson Reuters that are making significant investments in this arena will be well positioned to be the “leaders” in the market in the next five years. “The evolutionary form that will be successful, if I can use a hockey analogy, is to skate to where the puck is going to be as opposed to chasing after it. This success will be driven by vendor community, such as the one that we at Thomson Reuters have established and continue to nurture,” he claims.