Bringing Transparency to Pricing and Valuations

Trends and developments toward greater transparency in pricing and valuation functions had been increasing even before the onset of the credit crisis. At this point, we are moving into a post-crisis period of financial reform, and we are seeing unprecedented levels of scrutiny and requirements for firms to show procedural consistency in their complex deal pricing and portfolio valuation activities. Recent surveys of participants in securitization markets indicate disclosure and pricing/valuation methodologies as key starting points for restoring confidence in structured finance markets (see chart, below).

Regulators, investors, quasigovernmental organizations and government agencies are already driving for greater transparency and accountability. The emphasis is on a push for well-defined processes that are repeatable.

Despite collapses (or near collapses) in certain securitization markets, large portfolios of existing assets on the books need to be priced for ongoing net asset valuation (NAV) reporting, or for purposes of achieving "fair valuations" for exit scenarios in the absence of market-traded prices. Leading up to the financial crisis, as a consequence of how securitized investments were "loosely" created, sold and distributed -- in many cases involving lax (or even negligent) controls, careless valuation methods/assumptions and layers of complexity -- the process of "untangling," "re-inventorizing" and pricing the underlying assets can often be fraught with issues associated with judgment bias between current buyers/sellers, potential model design errors and the need to balance conflicts of interest.

Preparing for Reform

Industry reform is already on the way, but the full fallout is yet to be felt. To prepare for this, firms must:

• Move toward a federated "publish and subscribe" organizational model for pricing functions. Forward-thinking firms are embracing the notion of common pricing practices and a greater alignment of pricing within various parts of the business in order to achieve consistency and optimization of valuation resources. Both market and modeled-based derivative prices are required by various parts of the organization, especially for "horizontal" middle- and back-office accounting, collteralization, and risk measurement purposes, so it is important that firms begin to consider and assess the cost/benefits of such an alignment, with the aim of extending pricing capabilities towards "higher order" organizational functions who are the end consumers of this pricing data.
• Improve consistency of pricing analytics front-to-back across the value chain. We see the need for firms to achieve a higher degree of front-to-back linkage, in what we term as straight-through pricing practices (STPP). The best practice is to drive analytics consistency, standardization, and interoperability across the lifecycle of an OTC or structured deal. Firms should aim to reduce operational risks associated with model inconsistencies and lack of interoperability of front-end models with middle office and back office applications.
• Define a coherent strategy for a model development infrastructure. Financial institutions should recognize that the data environment for modeling is more complex relative than a typical application environment due to the high degree of data quality required. In order to support transparency and integrity of the model development process, firms should design / implement procedures and mechanisms for data quality and change control into the data and model development environments upfront, rather than retrospectively.
• Align front office, risk control and support interactions based on derivative product lifecycle dynamics. In areas of bespoke derivatives where product innovation cycles are short and frequent, we believe that firms should adopt distinct technology strategies / organizational models for newly introduced complex derivatives, as oppose to more stable, mature exotics and standard vanillas (e.g., "flow products"). A one-size-fits-all strategy is not likely to be effective. Based on anecdotal evidence, the differentiators in leading firms pertaining to control functions, come from a few distinctives: an ability to articulate a clear and consistent control framework, to adopt a balanced trade-off in consolidating position-keeping repositories, and to aggressively automate the information supply chain in product control processes e.g., P&L production.
• Establish pricing information transparency 'upstream' in order to inform control activities 'downstream'. Firms need to remove the information barriers and visibility of the "ingredients" that go into the creation of models and the pricing of trades. Being explicit about exposing key information requirements of control functions increases the productivity and effectiveness of control functions, as well as reduces risks of control functions failing to spot important mismarking incidents.
• Rethink building blocks that play into a pricing/valuation architecture. In the current distressed market, forward-thinking financial institutions are again taking a fresh, top-down view of how to create a "federation of production processes" and, when possible, to leverage offshore resources to reduce costs and increase productivity.

Rethinking Architecture

In the context of pricing, risk and finance activities, the scope of efforts has been growing to include entire business process chains (such as for corporate accounting) and subsequently knowledge-related processes (such as model validation, risk reporting, and business profit and loss reporting). These requirements demand a significant rethinking of the underlying architecture to not only enable scaling but also demonstrate production processes that are procedurally transparent and consistent across different business lines and in front/middle/back-office functions.

Looking forward, with pricing and valuation practices standing at the heart of future reforms, all firms participating in listed, over-the-counter derivatives and structured instrument markets need to develop a coherent strategy for executing derivatives pricing, risk management and product control with a higher degree of transparency, independence and accountability.

In the current state of brokenness, we are heading into an increasingly stringent post-reformation era in financial markets. There is significant rebuilding work to be done, and firms need to be smart in their routes toward recovering confidence and stature. Anything less is not likely to suffice.

Excerpts from this article were taken from the Celent study, "OTC Derivatives and Structured Product Pricing Practices: Trends and Technology Strategies for the Coming Market Reformation."

Cubillas Ding is a London-based senior analyst in Celent's securities and investments practice. His expertise lies in global financial markets, securities IT strategy and enterprise risk management. Ding's research focuses on market risk, credit risk, operational risk, and regulatory compliance, as well as the latest regulatory developments.