As the credit crisis continues to rock the U.S. economy, buy-side institutions that entered into OTC derivatives contracts with sell-side firms are taking steps to price the over-the-counter derivatives with independent, third-party sources. In the past, buy-side firms mainly obtained prices from their counterparties -- the investment banks that created the OTC derivatives instruments and calculated the prices with their own proprietary models.
"If I'm an investment banker creating these derivatives, who knows more [about them] than me?" says Paul Migliore, CEO of investment management consulting firm Citisoft North America. But since the broker-dealers often are on the opposite sides of these transactions -- and they stand to profit or lose money depending on the direction of the market -- relying on their calculations could pose a conflict of interest, he explains. "The big thing in the market is that no one trusts the dealers to price these instruments," Migliore adds.
Part of the problem is that OTC derivatives -- opaque, complex instruments that are linked to the movement of equities, interest rates, currencies and commodities -- are not traded on exchanges, so a true market price is hard to determine. Additionally, some derivatives are illiquid, making it even more difficult to value them.
Of course, as the credit crisis in subprime mortgages magnified and investors turned away from complex derivatives, including collateralized debt obligations (CDOs), dealers had an even harder time pricing them. Eventually, the dealers were forced to write down $150 billion in losses (as of press time) as a result.
Now the sell-side financial engineers and math whizzes responsible for valuing the OTC derivatives don't appear to be so smart. "Clearly, the sell-side has not done a good job of pricing these products," comments Michael Henry, the head of Accenture's financial services strategy practice in North America.
With uncertainty over how to price OTC derivatives roiling the entire fixed-income market, the buy side is seeking independent sources to validate The Street's bids and offers. "As a fund administrator, I need to find data points to come up with that valuation," explains Joseph Holman, founder and managing partner of Columbus Avenue Consulting, a hedge fund administrator based in New York with $6.5 billion in assets under administration.
"A market price, or any price, has to be observed; and to be observed, someone has to transact," Holman continues. "In the credit markets, where there's talk of a lack of liquidity, people aren't buying anything, and that affects valuations."
While mutual funds and hedge funds have been moving toward independent valuations of OTC derivatives for the past few years, the credit crisis has accelerated the search for neutral third parties to calculate and sign off on derivatives prices. "The CDO market environment was a wake-up call for the entire financial services industry," comments Judson Baker, derivatives product manager at Chicago-based Northern Trust, which offers an asset-pricing service for listed and OTC derivatives.
Independent Derivatives Pricing Gaining Momentum
The trend toward independent pricing also is gaining momentum due to the explosive growth in OTC derivatives trading by traditional asset managers and pension funds. Some asset managers have hundreds and even thousands of open derivatives contracts on their books, which they must mark to market from an accounting perspective, explains Citisoft's Migliore. "If one position is losing money, you have to go out and create another, synthetic derivative to offset the first derivative," he says.
According to Northern Trust's Baker, even though none of the clients of his firm's independent valuation service held customized CDOs, the subprime mortgage meltdown has had repercussions for pricing all derivatives. "The collapse of certain instruments [CDOs] had a profound ripple effect across all derivatives and their valuations," he says. "It's a call to arms for having robust and transparent valuations for your OTC derivatives."
Northern Trust began offering its OTC derivatives valuation service three years ago when it noticed a large spike in the number of derivatives its clients traded as well as a spike in the number of clients -- traditional pension funds (public and private), corporations, endowments, asset managers, hedge funds, mutual funds and private equity -- that had grown more comfortable with the use of derivatives. "We've seen tremendous [derivatives] volume growth in the last five years that outpaced the industry, sometimes three to five times over that," Baker relates. "We recognized the need to provide enhanced services for OTC derivatives," he adds, noting their offerings cover derivatives processing, independent derivatives valuation and collateral management.
To create the valuation service, Northern Trust hired three specialist firms: Markit Group; Bear Direct, a service of Bear Stearns; and SuperDerivatives. "That is their business -- to run models and collect data and to independently provide OTC derivatives valuations," says Baker.
According to Baker, Markit is a well-rounded provider in that it covers credit, interest rate, commodities, currencies and equity derivatives, and can handle all asset classes. SuperDerivatives, he says, specializes in currencies, equities and interest rate derivatives, but is getting better in commodities and is starting to cover credit derivatives as well. Baker adds that Northern Trust used Bear Direct for interest rate and credit derivatives because that is their strength as a sell-side firm; he notes that Bear had a "Chinese wall" between the trading desk and the asset-pricing service.
In light of the collapse of Bear Stearns and its fire sale to JPMorgan Chase, however, Baker says Northern Trust is reexamining its relationship with Bear Direct. "After the issue with Bear Stearns surfaced, we have closely monitored their output and service," he notes. "We continue to use Bear Direct, but have reverted to using them as a secondary source. We are assessing their business model and will soon determine if and how our relationship will change."
Avoiding Conflicts of Interest
Before Northern Trust launched its valuation service, the bank's clients relied on their investment managers -- who either used their own proprietary risk management models or counterparties' (i.e., brokers') prices -- to value derivatives, Baker reports. But "having your investment manager supply a value that they could manipulate is not objective," he stresses, adding that this potential conflict of interest was a major driver behind Northern Trust's decision to develop a more independent audit check for its clients. Another reason that drove Northern to develop a more independent audit check was their focus on governance best practices.
If the investment manager has control over the pricing model, "They could tweak the model and they could manipulate the price to something they want it to be," suggests Baker. "It's not in the client's best interest, and sometimes the investment manager's compensation is based on the performance of that derivative. They could inflate the price of that derivative, and their compensation could be based on it. So obviously we saw a conflict of interest there."
This apparent conflict of interest may be the No. 1 driver behind the buy side's push for independent derivatives pricing services. "Investors are saying they want independent looks at the books," asserts Ed Crouch, global head of corporate and strategic development at SuperDerivatives. "Auditors say they want independent looks [too]. These two things have led the revaluation part of our business to explode."
According to Crouch, SuperDerivatives is seeing a dramatic increase in demand from buy-side firms for valuation services in order to put a fair market value on their books of derivatives holdings. "Global custodians are saying they have trillions of dollars of this paper and it hasn't gone away, and they need an independent market of that book," he comments.
At the same time, hedge funds also are pressing their fund administrators to obtain an independent price source. In January, for example, Columbus Avenue Consulting selected SuperDerivatives' Credit Derivatives Platform, SD-CD, to price its hedge fund clients' portfolios of credit default swaps. The firm uses Bloomberg to price equities and spot currencies.
Buy-side participants maintain that vendors are more neutral than broker-dealers because they are not involved in the trades. "The vendors have no idea which side the trade is on," says Northern Trust's Baker. "They don't even know the quantity [of the positions]. We don't share client data or even which side of the trade our client is on. The notionals and quantities remain protected. They value the instruments by collecting data for their models. It's not skewed to the bid or ask side either," he adds, noting that the vendors' valuations typically fall at a midpoint price.
Further, there are a number of vendors in the derivatives valuation space to choose from. "We think with those three primary firms we get best-of-breed independent valuations," Baker says, referring to SuperDerivatives, Markit and Bear Direct. Northern Trust, he explains, gets values back from two or three of those sources and then compares them to see how they stack up against each other. Baker calls this a valuation hierarchy.
Columbus Avenue Consulting's Holman confirms that the industry is reducing its reliance on single sources for derivatives prices. "You see a lot of reliance on a variety of sources," he says, noting that there are different methodologies for comparing the various sources.
"We use multiple pricing services now, which I would never have considered [previously]," Holman adds. "It used to be that you looked at one broker quote -- you looked at the bid or took the mean of the bid-ask. Today we're creating matrices of broker quotes. We'll take three broker quotes and we'll come up with an average bid-ask spread, and we'll take the average of that bid-ask."
Different Pricing Strokes for Different Folks
According to Mayiz Habbal, SVP of Celent's securities and investments practice, the buy side has three options when it comes to figuring out the right approach to pricing OTC derivatives. The first choice -- the easy approach -- is to use the counterparty price when valuing the position, he says. The downside, of course, is that there's no transparency into the sell-side's model. "Since it's not independent pricing, there may be errors, and the counterparty doesn't provide the price on a regular basis," Habbal comments. "If you want to do it cheaply, that is what you would do. [But] then you would be exposing yourself tremendously."
The second approach, Habbal says, is to set up an internal valuation entity within the asset management firm. This method hearkens back to the mid-1990s when the investment banks came up with analytics to manage the derivatives they were selling.
"The differentiation is how [sell-side firms] manage the risk for what they are selling," Habbal explains. "Jumping over to the buy side, you see the buy side trying to do the same." If a buy-side firm has deep pockets and enough knowledge of derivatives, Habbal adds, it will set up an internal valuation unit. A perfect example of this is hedge funds that internally price OTC derivatives to figure out if there are any arbitrage opportunities.
The advantage of this option is that the buy-side firm has complete control over and transparency into the pricing process. In the long run, it's helpful to understand the instruments, Habbal says. However, on the downside, this entails heavy infrastructure costs and investments in market data implementation and people.
"You will add another complex process that will also consume a lot of internal resources," Habbal warns, adding, "Once you have the function, you have to keep pumping money into [it] to keep it going."
While some analysts say the buy side, with the exception of hedge funds, lacks the expertise to undertake a project of this kind, Putnam Investments developed its own internal OTC derivatives calculation engine to gain competitive advantage. "We have financial engineers on staff that understand these instruments -- that understand the modeling -- almost as well as the business," says Eric Meltzer, Putnam's head of investment technology at Putnam Investments in Boston.
The third option, according to Habbal, is to find an independent evaluator. Vendors typically offer valuation services via an application service provider (ASP) model, in which the asset manager sends its trades, terms and conditions over the Internet to the vendor and gets prices back, he notes. The benefits of this model include cost efficiency, scalability and flexibility, says Habbal.
One negative, however, is that "expertise will not be nurtured internally," Habbal points out. But while many of these services are "black boxes" that offer the buy side little transparency into vendors' models, the vendors often will share some details, he adds.
Banks that have the money, Habbal predicts, will develop their own internal OTC derivatives valuation capabilities and also explore third-party pricing services. "That is the ultimate [solution]," he says.
Citisoft's Migliore, however, says he doesn't know of a lot of asset managers building their own models to price derivatives. "We're not seeing anybody wanting to build their own OTC derivative valuation systems themselves -- they are looking at vendors and products out there," he contends, pointing out that "There are third-party pricing services that are out in the marketplace right now that [asset managers] can bring in-house to price their assets."
In addition, "Buy-side firms are looking to their current third-party custody bank relationships and fund administrators to provide this stuff," says Migliore. "A lot of asset managers are asking their custodians to price OTC derivatives." Global custodians "sit in the middle -- they work with the asset managers and the broker-dealer community, and they do the settlements," Migliore explains.
The Data-Collection Burden
For its part, Northern Trust decided to partner with vendors not only to increase speed to market, but also to relieve itself of the burden of OTC market data collection and the interpretation of that data, according to the firm's Baker. "The hard part about valuation is not the model, because the models are so standard now," he says. "It's more about collecting the data."
Data collection involves polling brokers and arranging to have multiple broker-dealers transmit live trading information back to the firm, Baker says. In the end, Baker adds, the goal is to provide complete transparency into the OTC derivatives pricing process.
To do that, a firm has to be able to show which entity provided which value, how and when the price was updated, and whether the price was fresh or stale, Baker notes. In addition, the firm must monitor the sources of data to provide a consistent and accurate source of data day after day and month after month, he says. "It's very difficult, very risky and it's not where we are positioned," Baker explains.
But even though Northern Trust relies on vendors to aggregate the information on which derivatives prices are based, the firm still is heavily involved in the valuation process, Baker stresses. "We're constantly reviewing how actively that data is updated, and if there is a concern the inputs are stale, we do everything we can to initiate better inputs," he says.
Further, Northern Trust continually is expanding the coverage of its service to keep pace as its vendors pick up other derivatives instruments. "There's always development taking place -- there's always capital assigned to [the asset service's] expansion," Baker says. "[Independent derivatives pricing] is definitely one of the crucial parts of the industry."
Also in the same article -
Putnam Investments Sees Competitive Advantage in Building OTC Derivatives Pricing Engine In-House
MARKET PARTICIPANTS are upgrading their technology to improve derivatives processing
Source URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=207200087
Publish Date: April 22, 2008
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