For exchange-traded assets, pricing is relatively straightforward. Even so, volatility in the markets has necessitated more regular tracking of changes in prices as firms look to steer away from excess volatility.
For the more complex, over-the-counter (OTC) instruments – where prices are based on mathematical models and academic structures rather than any centralised market price – a whole new approach is necessary.
The shortcomings of previous pricing processes became starkly evident in the fallout from the Lehman Brothers default as various positions in the derivatives markets were unwound. It soon became clear that for many of these highly structured products where valuations come with some subjectivity, no-one could agree on a fair price and no-one could, therefore, be sure of the value of their portfolios.
General guidelines have existed for some time, encapsulated in the likes of Basel II and Ucits III legislations, and more explicit regulation is expected to follow.
But the demand for independent pricing is being driven by investors as much as law makers.
Independent valuation firms, like SunGard Reech, SuperDerivatives and Markit Partners have been around for some time but had not been used by many fund managers, who, in many instances, prefer to rely on their sell-side counterparts for the valuations. This process could be considered naïve. As Gavin Lee, chief operating officer at SunGard Reech, says: “I am still shocked that some fund managers think that it is good enough to get a valuation from the other party in the transaction.”
This attitude is changing though and has largely evolved from carrying out the bare minimum of work, to taking full control of the process and ensuring that valuations are fair and not just intended to keep clients happy. “There is a clear desire to go beyond the old approach and have truly independent pricing,” says Christophe Lentschat, head of sales, product development and marketing at EFA, a Luxembourg-based fund administrator.
The more enlightened fund managers are producing written pricing policies and establishing committees involving key executives rather than just portfolio managers. It is an entirely new process in many cases and the work involved, particularly for the fund administrators contracted by the fund managers or promoters, has probably shown them why they settled for such a slack strategy in previous and less scrupulous times.
“As a fund administrator, we need to be able to provide the capacity to organise the whole process, although not necessarily perform all of the process,” says Lentschat. “This includes selecting the data sources, managing the data, verifying the data, dealing with any deviations that may arise and being able to document the whole process.”
On the trail
The need to display a clear audit trail is one of the biggest changes in approach, according to Daniel Simpson, chief executive of data management vendor Cadis. “Everyone has a process in place and some valuation tools and technology but what they are struggling with is being able to demonstrate this process to their external clients and regulators and produce an audit trail, particularly if they have been running all of their valuations out of a black box.”
The other major challenge is managing the multiple data sources that are now essential to truly independent price verification. “We use multiple sources for our pricing,” says Lentschat. “We do some of it ourselves and we also use some of the new information providers that specialise in derivatives. As a third-party administrator we have been dealing with this challenge for a while now so the system that we use was always designed to be able to take in multiple data sources and deal with multiple cut-off times.”
Lentschat says that EFA will sit down with each client and discuss what the best pricing process is and then organise the different data sources and documentation. The cost and complexity involved is, he says, largely dependant on the type of instruments in the portfolio.
“For those instruments that are commoditised, we are able to run proven models and the cost is marginal. However, if the instruments are still new and OTC, and if they are not spread over many portfolios, then it remains more costly. There is always a trade-off between what returns you think the instrument can bring and the cost of administering those funds, but we have seen no real restrictions in terms of asset selection – although, in theory, this could happen,” says Lentschat.
Vernon Barback, chief operating officer and president of GlobeOp Financial Services, a third-party fund administrator, agrees that independent pricing is more costly for more complex portfolios, but he sees no sign of this extra cost affecting the popularity of OTC and less liquid instruments, particularly while the current credit crisis is still in full flow. Therefore fund administrators have little choice but to invest in providing a sophisticated and costly pricing service.
“The capabilities of fund administrators differ and managers setting up new funds and investors in those funds are being careful in conducting due diligence on the individual administrators they use,” says Barback. “For the administrators it’s not just money, it’s time. They have to build an experienced staff with a broad set of domain expertise and quantitative capabilities. Developing the technology and processes of a robust and transparent valuations service is a considerable commitment.”
They also have to deal with the task of managing multiple data sources. “The key is the ability to sift through all of those sources and make the appropriate calculations such as discounting the highest and lowest prices and averaging the rest. In addition there are different tolerance levels for different fund and strategy types,” says Barback.
“These are all significant requirements that a sophisticated fund administrator would need from its valuations engine. As far as we have experienced there are no all-encompassing systems available off-the-shelf from third parties so any firm that wants to compete in this space will have to make considerable investment in time and money to meet these needs.”
Many fund administrators are facing an entirely new process, says Lee, at SunGard Reech. “They have to first identify all the pricing data sources, then ensure that these prices are coming in consistently. They will most likely arrive in different data formats so that has to be dealt with before it is possible to analyse the data and put it into some form of comparative process. Administrators also need to build in a set of rules concerning tolerance around any price deviations.”
Lee says that Reech tries to be as flexible as it can in terms of data formats but so far there is no industry-wide initiative to introduce any standard data formats. “There are some vendors out there that offer a data aggregation service for clients that take all of this data and put it into a single format and there is good reason to think that this might become the accepted approach in the future.”
GoldenSource, a data management platform vendor, is currently marketing such a tool. “The idea behind the product is that it does not matter what asset class, data source, tolerances or other variables are involved – it will still fit into the GoldenSource ‘golden record’ process,” says Gert Raeves, senior vice president, strategic development, at GoldenSource.
The data requirements around independent pricing are yet another argument in favour of single-source processing and against the silo approach to data, says Raeves. “The smart firms will have data integration policies which saves having to spend extensively on process integration platforms and adding yet more layers to the overall infrastructure. The important objective is to be able to provide this pricing data from a shared layer to the risk managers, the client reporting team and the regulators.”
A lot of market education is still needed, says Raeves, to prevent firms from just slipping back into old habits. “The industry is increasingly working with a bunch of new pricing providers But if you have new data sources, don’t implement each one on a standalone basis. It would ruin all the good work.”
It is also a relatively easy problem to solve that need not be expensive, argues Raeves, but unless it is addressed in a timely fashion there is always the risk that independent pricing falls into the same processing quagmire as other functions. “It is important that independent pricing does not become the next corporate actions – an area which is in a rut, rife with manual processes and where firms just hire more people. It becomes a backwater of the processing world. But pricing is a lot simpler than corporate actions so people have to understand that they can solve this and in a far less expensive way than they are doing at the moment.”
©2009 funds europe