Analyst Celent has responded to the buzz around valuations for OTC derivatives and structured products with a report released this month in which it compares risk and pricing analytics solutions to support financial engineering and valuation functions. To put the importance of these solutions in context, Celent predicts that the combined notional value for all derivatives will break the $500 trillion mark in 2008.
In its paper, Risk and Pricing Analytics: Addressing Valuation Challenges in OTC and Structured Products, Celent concludes that institutions implementing pricing solutions need to strike a balance between a number of priorities. Report author Cubillas Ding says they “need to weigh the level of granularity required for their OTC derivatives and structured products valuation activities, the type and nature of users, and time to market considerations in the context of the availability of internal resources”. “Each approach trades off granularity, end user focus and time to market,” he adds.
Celent profiles eight vendors – FinCAD, NumeriX, Pricing Partners, Quantifi Solutions, SciComp, SunGard Reech, SuperDerivatives and UnRisk/MathConsult. Criteria for a provider’s inclusion in the report were that it had a fully built-out product, that it had a significant focus on analytics for illiquid instruments (as opposed to the provision of market data), and that it had a sufficiency of clients. Vendors that either did not respond to Celent’s stipulated deadlines or declined to be involved in the assessment included Barra/FEA, Markit, MBRM, Lombard Risk (Independent Valuation Service) and S&P.
According to Ding, “the determination of fair market value for the positions that make up a complex trade, fund or portfolio is, more often than not, fraught with complications”. “Complexities often arise from multi-layered product valuation requirements, the fault-prone use of spreadsheets and the transparency of valuation processes,” he says. Vendors seeking to address this challenge have adopted different “routes to market” for pricing analytics, Celent suggests. Solutions are differentiated across several lines: specialised versus mixed asset models, coverage across various parts of the OTC and structuring lifecycle, the scope of the vendors’ analytics and the quality of partnerships related to market data, integrated trading and risk management systems.
As well as ranking the eight vendors according to size, breadth of functionality and how advanced their technology is, Celent also offers in its paper some “lessons learned” for addressing valuation risks, based on its conversations with market participants.
These include ensuring alignment between transactional/deal-level pricing and portfolio risk management. To achieve alignment between deal and portfolio activities, firms need to ensure independence between front office pricing and back office portfolio revaluation responsibilities, functions and price data, especially in the context of OTC and structured deals, Celent says.