Evaluated Pricing Market Insights Transparency And Evaluated Pricing
CONTENTS About this White Paper...3 The Focus on Transparency...3 What Does Transparency Mean?... 3 Inputs... 4 Assumptions... 4 Methodology... 4 Other Transparency Considerations... 4 Access to the Data... 5 Third-Party Suppliers Processes and Controls... 5 What s Pushing Transparency in Evaluations up the Agenda?... 6 02 Key regulations impacting evaluations transparency... 7 Accounting rules... 7 IASB... 7 FASB Topic 820... 8 ASU 2011-4... 8 MiFID II & MiFIR... 8 Dodd-Frank Act, EMIR, UCITS V... 8 AIFMD, InvRBV... 8 Your 10-Point Checklist for Ensuring You Meet the Transparency Requirements... 9 Summary...10 About Interactive Data...11 About A-Team Group...11
ABOUT THIS WHITE PAPER >> In this paper, we take a look at why transparency in the valuation process is important, which regulations demand that attention is given to your transparency policies, how firms should adapt their evaluations data strategy to meet client and regulatory requirements. We also provide a check list of 10 key things financial institutions need to think about in order to satisfy the transparency needs of their clients, auditors and regulators. << THE FOCUS ON TRANSPARENCY >> An evaluated price is an informed opinion about the value of OTC instruments based on a myriad of inputs current market trade prices and quotes including those for similar securities, cash flow assumptions, economic events, and more. Knowledgeable analysts then combine those inputs with tools and, using a defined methodology, create a mark-to-market value for that instrument. Transparency into just how these valuations are generated and used at financial institutions is a key focus for investors and for regulators. This increasing scrutiny of the pricing behind their trading activities means that firms now have to systematically justify how they value instruments. So it is essential for the financial institution to ensure its evaluations processes and workflow provide the right level of transparency to satisfy these demands. 03 With the trend towards using independent evaluations data suppliers growing, getting the right level of transparency into the models and inputs used by those suppliers is essential. So as well as focusing on their own internal valuations methodologies, financial institutions need to ensure they know what methodology their counterparties, brokers, and third-party suppliers follow. << WHAT DOES TRANSPARENCY MEAN? >> There are a number of inputs, assumptions and models used to generate an evaluated price, and transparency is about being able to access and understand those factors. It is those factors and the methodology that is applied, that gives you the context of that price in relation to the marketplace, which is what you need to be confident that you are marking your instruments, especially the less liquid ones, to market and providing fair value to your clients. We ll look at all the aspects that give you transparency into your evaluated pricing.
When looking specifically at external suppliers, there are a number of aspects of transparency to look at. According to valuations data managers surveyed in October 2011 by Interactive Data, key things to look for include a methodology and the response to price challenges (see Chart A) << INPUTS >> You need to ensure you have, and can show, transparency into the market data inputs that are used either by your internal pricing teams or independent suppliers, in order to show how you have reached the valuations you intend to use. The range of data used can include, for example: reported trades, broker/ dealer quotes and data for comparable bonds. 04 Transparency is also about showing the range of other inputs going into evaluations, such as benchmark curves, derivative information applied to the bond market, ratings, and cash data. You should also look to see if there are data available about the liquidity in any security to understand the impact on the valuation, and how distressed trades and securities are handled. Having transparency into the inputs making up your evaluation is particularly crucial for the IASB/FASB fair value standards and to be able to categorise your valuations at the right level of hierarchy. If you use external evaluations data suppliers an increasing number of firms do (see Chart B). another consideration related to inputs is their range of underlying data and scale of resource that enables them to react to market changes (particularly in those times of increased volatility). This can be assessed through both due diligence sessions for general understanding and specific up to date information on the data. ASSUMPTIONS The next level of transparency involves understanding what assumptions are made to get to your evaluated price. These can range from the spread (say of corporate bonds over a benchmark), to weighted average life, to constant default rates (CDRs) for mortgage-backed securities, and more, that are all combined and analysed to give you the evaluation. The data used to achieve this include corporate actions, reference data such as terms and conditions, market benchmarks (yield curves, LIBOR, etc.), industry and economic events, academic sources and more.
METHODOLOGY A methodology formally describes the process used to combine all the inputs and assumptions, the use of tools and/or models, the evaluator s assessments, and other approaches in creating evaluated prices. Being able to articulate your own methodology, as well as understanding the methodology of any independent evaluations data suppliers, and having confidence in their robustness is essential to giving you transparency into the process; as is explaining this transparency to users of valuation data. OTHER TRANSPARENCY CONSIDERATIONS Being able to challenge prices and knowing how the challenges are dealt with is an important consideration for transparency. You need to ensure you have a defined process internally and externally with your data suppliers for investigating prices that fall outside your set thresholds. You need to figure out what approach best fits your workflow so that you handle them in an efficient way and then ensure any suppliers can meet those needs. Some suppliers now provide direct access through a web-based challenge portal that enables you to log single or multiple challenges, and then review the progress of those challenges throughout their life cycle at any time, giving you transparency into the process. This kind of facility can help with your workflow processes and reporting. 05 ACCESS TO THE DATA Ideally you need a single point of access to that underlying data in a timely way (see Chart C) so that you can freely interrogate it to satisfy your own internal needs, those of your clients and of your auditors. You also need to know that the data is not stale but is unchanged and continues to reflect current market data. It is also important to understand what kind of access to the pricing analysts is available in order to resolve any questions you have about the data. Having the communication channels in place to communicate with the analysts effectively can be invaluable. THIRD-PARTY SUPPLIERS PROCESSES AND CONTROLS When dealing with third-party suppliers, other considerations include what level of transparency they provide into their processes and controls, and into their operations and business continuity plans.
WHAT S PUSHING TRANSPARENCY IN EVALUATIONS UP THE AGENDA? Culturally, there is a real drive for openness as people increasingly expect access to all sorts of information, in part due to the instant access now possible though the Internet, but also as we look to implement best practices in an effort to avoid repeating the major political and financial crises of recent years. As this effect trickles down into financial services, clients, auditors and regulators are pushing for such openness in how financial institutions invest, resulting in a need for greater transparency. Internally, there is a real desire to better manage risk, which in turn impacts the need to challenge pricing assumptions behind investment activity. As part of your firm s risk assessment processes, they should ensure there is no bias or manipulation in pricing, which can be achieved by ensuring there are clear policies and procedures that address key risks and are executed consistently. Relatedly, there is increasing use of risk-adjusted pricing, which makes it harder to then drill down into the underlying data. 06 Also putting pressure on the institutions are the auditing firms who look for proof that the financial institutions investments on behalf of their clients are believed to be sound and that they meet regulatory requirements, in addition to the sign off of financial statements. Clients are one of the most important drivers at financial institutions. And in the current climate, many clients are cautious and want to know they are investing wisely and so are now paying more attention to how their portfolios are being priced. Financial institutions, are increasingly finding their clients asking questions about such things as the underlying methodology for setting pricing tolerances, or the components that make up the NAV calculation (which remains the most important consumer of valuations data). Please see Chart D for what our survey found drives the need for valuation transparency in financial institutions. As ever, the external compulsory requirements of regulations help to raise the issue up the priority list. We ve provided a guide to the many regulations impacting the need for transparency in the next section. <<
Key regulations impacting evaluations' transparency Industry area ACCOUNT- ING RULES Regulation, Directive or Body IASB & FASB Why it Impacts the Need for Transparency in Evaluations The International Accounting Standards Board (IASB) and the US-based Financial Accounting Standards Board (FASB) have been working together on a fair value measurement project to harmonise the measurement and disclosure requirements in the two regions accounting and reporting standards. It is widely anticipated that the US will move from GAAP principles to IFRS in the future. But in the meantime, the convergence efforts have resulted in a number of amendments to existing accounting standards and the creation of new standards that have an impact on the transparency requirements for evaluations. IASB A common thread between the two boards is the use of a three level hierarchy for security fair valuation (see below). This requires the user to assess the inputs and assign a level, which in turn requires increased transparency in the valuation process around the inputs. Ü Level 1 quoted prices in active markets for identical assets or liabilities Ü Level 2 inputs other than quoted prices included within Level 1 that are observable for the assets or liabilities, either directly (i.e. as prices) or indirectly (i.e. derived from prices). Ü Level 3 Inputs for assets or liabilities that are not based on observable market data (unobservable inputs). These levels are also intertwined into other regulation such as Basel III. The IASB has introduced three new standards which impact on valuation and the transparency required, namely IFRS 7, 9 and 13. IFRS 7 focuses on financial instruments disclosures made by the reporting entity so that users can evaluate both the significance of financial instruments for the entity s financial position, and the nature of risks from those financial instruments and how it manages those risks. It uses the three levels referenced above. IFRS 9 is a classification standard for financial assets and liabilities that establishes two primary measurement categories: amortised cost and fair value. If the classification made is for fair value, then IFRS 13 applies. Transparency about the purpose of the holding and the type of instrument is required to make that assessment. 07 IFRS 13 was published in May 2011 and is due to come into effect in January 2013 although early adoption is allowed. Its objective is to define fair value, provide a framework for measuring fair value, and requires disclosure about those fair value measurements in order to improve transparency. It also uses the three level hierarchy and requires the same transparency as IFRS 7.
industry area Regulation, Directive or Body Why it Impacts the Need for Transparency in Evaluations ACCOUNT- ING RULES FASB TOPIC 820 Asu 2011-4 Topic 820 formerly known as FAS 157 is the US-GAAP-based equivalent fair value measurement standard for financial statements. It contains the original three-level hierarchy upon which the IFRS rules are based. It s worth mentioning this recent (May 2011) update to Topic 820, which calls for further transparency into Level 3 assets. It states the report entities should disclose quantitative information about the unobservable inputs used in a fair value measurement that is categorised within Level 3 of the fair value hierarchy. Post trade transparency MiFID II & MiFIR The EU has brought out two proposals, one for a directive and one for regulation, to extend and expand on the original MiFID directive, especially in the area of non-equity OTC instruments. 08 The proposals for pre-trade transparency require both quotes and depth of quotes from all trading platforms to be made public. Post-trade transparency requires all trades to be made public as close to real time as possible. Both requirements, however, can be waived or delayed upon application by the relevant national regulator. For valuation users, these proposals will enhance the information available for direct securities being evaluated and provide additional colour to allow further securities to be evaluated. This additional transparency should be provided to support evaluations. OTC Derivative regulation Fund management regulation DODD-FRANK ACT, EMIR, UCITS IV AIFMD, INVRBV A number of regulations are focused on improving transparency in the OTC derivatives markets. Dodd-Frank and EMIR will require centralised clearing (2012) of derivatives and include daily mark to market requirements. This will require an increased level of transparency, especially audit trails and methodologies. UCITS IV states that OTC derivatives are subject to reliable and verifiable valuation on a daily basis. But the valuations are no longer able to be set by the negotiation between the two parties of the contract these are required to show a valuation from an independent third-party or a unit independent of the portfolio management of the UCITS. New regulation in Europe is impacting the requirements to both use independent valuations and have these processes transparent and open. AIFMD focuses on alternative fund management and InvRBV focuses on the German fund management industry.
YOUR 10-POINT CHECKLIST FOR ENSURING YOU MEET THE TRANSPARENCY REQUIREMENTS >> So just what can you do to make sure you get the right level of transparency into your evaluations processes? Here is our checklist for the top 10 things to consider and build into your drive for transparency. Know What Underlying Market Data is Being Used to Support the Evaluation Ensure you have transparency into the market data inputs used internally and by evaluations data suppliers. This is particularly crucial for accounting regulations to assign the right level of hierarchy to that valuation. Know What Assumptions are Made From spreads to CDRs, knowing the assumptions will help you understand how the evaluation has been reached. Know What Other Inputs Go into Evaluations Other inputs such as cash flows, benchmark curves or risk adjustments, need to be transparent. Also consider aspects such as how liquidity is factored in, or how distressed trades and securities are handled. Make Sure You Have a Methodology Having access to documentation describing the process for combining inputs, assumptions, models, personal evaluators assessments and more, is an important method of demonstrating transparency both from your suppliers and to your clients, internal audience and auditors. 09 Get Access to the Information Make sure you have the right level of access to the underlying data and assumptions made by third-party evaluations data suppliers. Some vendors now provide advanced tools that give you direct and integrated access, or self-service, to underlying market and evaluations data in order to provide you with the flexibility you need, and the ability to fit it into your own workflow. Be wary of vendors that are not willing to give you the level of transparency you need. Have a Defined Process for Handling Price Challenges You need to have a clearly defined process that fits into your workflow for investigating prices falling outside your set thresholds, both internally and with data suppliers. Again, look for vendors providing advanced web-based portals for managing the price challenge process. Search for the Highest Quality Data Analysts Market intelligence is an essential ingredient in an evaluation that accurately represents the market, and the quality of the data analysts involved can make the difference. Have you got the right team? And what do you know about the data analysts at your third-party suppliers? How many data analysts do they employ and what level of qualification do they have? Can you talk directly to their evaluators?
Evaluate Your Suppliers Controls What transparency do your third-party suppliers provide into their processes and controls? Do they have documentation for, and can they demonstrate, the controls, processes and procedures they follow? As well as satisfying your own internal needs, these reports can save costs in satisfying your auditors of your suppliers controls, which they might otherwise have to do themselves. Evaluate Your Suppliers Technology Robustness As well as having transparency into your suppliers data and processes, you also need transparency into the operations of your suppliers. Are they willing to host due diligence meetings? What does their infrastructure and business continuity plan look like? Are they a stable company that you can truly have confidence in for the long term? And do you have confidence in their ability to handle the scale of data provided and to meet your delivery requirements? 10 Understand the Market s Transparency Issues You need to keep up with the everchanging landscape of regulations and how they impact the transparency requirements that your clients, auditors and regulators will have. You should also keep informed of what services are available to you to help you provide the right level of transparency. Keep reading reference material and documents issued by the regulatory bodies; search for useful publications which track developments; network with your peers at industry events to hear the latest and understand how they are dealing with the challenges; and turn to your evaluations suppliers for help here too how much support and education do they provide about the twists and turns of the latest regulations and their impact on your evaluations processes? << SUMMARY >> As we ve seen, gaining transparency into the inputs, assumptions and models used to generate an evaluated price is essential in giving you the confidence you need to know you are marking less liquid securities to market and providing fair value to your clients. As well as serving your goal of meeting client needs, other drivers to consider include satisfying auditors, ensuring you can meet your company s own internal risk management needs, and meeting external regulatory requirements. Your 10-point checklist can be used to support your drive for transparency in evaluated pricing. <<
About Interactive Data Interactive Data is a leading provider of independent pricing and valuation services. Backed by decades of experience, Interactive Data is an industry leader in evaluated pricing, setting the standard for coverage, quality and reliable delivery. More than 5,000 financial institutions in over 50 countries, including central banks, investment banks, major mutual and investment fund companies, use Interactive Data s evaluated pricing services. Pricing, evaluations and reference data are provided in the U.S. through Interactive Data Pricing and Reference Data, Inc. and internationally through Interactive Data (Europe) Ltd. and Interactive Data (Australia) Pty Ltd. www.interactivedata.com About A-Team Group A-Team Group, founded in 2001, is a publishing, research and events group focused on Low Latency trading infrastructures, Reference Data and Risk Technology for the global community of IT and data professionals in financial markets. We provide online news analysis and resources via our Low-Latency.com, ReferenceDataReview.com and Risk-Technology.net websites. We make a wide range of in-depth research reports on specific topics, and our benchmarking of valuations data services, available via our websites. Our series of events include our Low Latency Summits and Data Management Summits in New York and London. Our customers include senior decision makers, from data to infrastructure managers at financial institutions across Europe, North America and Asia. 11 Find out more at www.a-teamgroup.com. Contact Martyn Hodges A-Team Group E-mail: martyn.hodges @ a-teamgroup.com Tel: +44 (0)20 7096 8444
About Interactive Data Interactive Data Corporation is a trusted leader in financial information. Thousands of financial institutions and active traders, as well as hundreds of software and service providers, subscribe to our fixed income evaluations, reference data, real-time market data, trading infrastructure services, fixed income analytics, desktop solutions and web-based solutions. Interactive Data s offerings support clients around the world with mission-critical functions, including portfolio valuation, regulatory compliance, risk management, electronic trading and wealth management. Interactive Data is headquartered in Bedford, Massachusetts and has over 2,500 employees in offices worldwide. Pricing, evaluations and reference data are provided in the U.S. through Interactive Data Pricing and Reference Data, Inc. and internationally through Interactive Data (Europe) Ltd. and Interactive Data (Australia) Pty Ltd. For more information, please visit www.interactivedata.com. Amsterdam Bedford Chicago Cologne Dubai Dublin Frankfurt Geneva Glasgow Hayward Helsinki Hong Kong Irvine Jersey,CI London Luxembourg Madrid Melbourne Milan Minneapolis New York Paris Rome Santa Monica Singapore Sydney Tokyo Toronto Zurich North America Interactive Data 100 William Street New York, NY 10038 USA Tel: +1 212-269-6300 Fax: +1 212-771-6987 email: info @ interactivedata.com Europe Interactive Data Fitzroy House 13-17 Epworth Street London EC2A 4DL UK Tel: +44 (0)20 7825 7800 Fax: +44 (0)20 7825 7801 email: eu-info @ interactivedata.com Asia Pacific Interactive Data (Australia) Pty Ltd 1155 Malvern Road Malvern Melbourne Victoria 3144 Australia Tel: +61 3 9249 2000 Fax: +61 3 9249 2001 email: info @ interactivedata.com Limitations This document is provided for informational purposes only. The information contained in this document is subject to change without notice and does not constitute any form of warranty, representation, or undertaking. Nothing herein should in any way be deemed to alter the legal rights and obligations contained in agreements between Interactive Data (Europe) Ltd and its clients relating to any products or services described herein. Nothing herein is intended to constitute legal, tax or other professional advice. Interactive Data (Europe) Ltd makes no warranties whatsoever, either express or implied, as to merchantability, fitness for a particular purpose, or any other matter. Without limiting the foregoing, Interactive Data (Europe) Ltd makes no representation or warranty that any data or information (including, but not limited to, evaluations) supplied to or by it are complete or free from errors, omissions, or defects. 2011 Interactive Data (Europe) Ltd