Market volatility and shaky counterparties have focused attention on valuation methodologies and the data underpinning them, finds Brian Bollen

Anyone or anything that needs a frequent, consistent and independently generated valuation of an asset - whether for risk management purposes, product control, marking to market, for the profit and loss account, or for regulatory and capital adequacy purposes - will need no reminding of how important this has become over the past two years. “When you get a G20 communiqué talking about valuations you know it has shot way up the list,” comments Peter Jones, global head of Standard & Poor’s valuation scenario services.

The importance of transparent and independent pricing in the OTC derivatives world in particular has never been more important than it is today, when the ability to price an asset quickly, confidently, accurately and consistently can mean the difference between success or failure for an investment strategy, or even an institution. “We have seen the value of some funds drop dramatically in a very short time due to the wrong valuation of a portfolio by a counterparty, especially the OTC derivatives element,” says Philippe Rozental, co-head of SGSS Asset Servicing. “Asset managers need to have transparent, independent valuation and pricing models that they can turn to in order to challenge a counterparty’s pricing. A provider of pricing services needs to be able to prove that it has complete independence from the counterparty price. As the first bank in the securities services industry to offer pricing of complex derivatives, most of the time we will challenge a counterparty’s price, especially when we receive a mark-to-market notification for an OTC.”

For Michael Hunt, managing director, global fund operations at Russell Investments, consistency is a must, but so too is comprehensibility. “We need to make sure we understand the whole process, and our valuations committee works closely with our third-party administrator, State Street, on a daily basis,” he says.

The title of a recent paper from the independent research firm Aite Group says it all: Getting a mark is no longer enough; valuation risk goes beyond pricing. It points to the impact of the combination of product innovation in the development of complex securities, regulatory and accounting requirements and investor scrutiny.

Many types of risk-related data and processes, once considered inconsequential, must now be incorporated into the overall risk management scheme. The study notes that buy-side firms and fund administrators have expressed reduced confidence in the availability and quality of marks from broker-dealers as the decline in the number of major sell-side participants makes conflicts of interest more apparent.

It adds that price challenges have recently increased up to five-fold due to market volatility, straining back-office resources and increasing the risk of incorrect valuations.

Aite lists seven questions facing the middle and back office. What level of assurance is there on the quality of valuations - the methodologies, models and key assumptions? What evidence is there that valuations are representative of fair value market price? Do we understand all the features of complex security holdings? Do we know to what extent the price reflects credit, liquidity, counterparty and market risk? How sensitive are our valuations to changes in assumptions or the market place? Do we know that we have identified all risks? Can our valuation and risk systems keep pace with the speed of the markets we operate in?

And the answers? “We, and our clients, are becoming more sophisticated both in terms of valuation technology and the ability to compare like with like to arrive at comparable valuations of different assets,” says Jones.

The increase in sophistication could be portrayed as a return to basic first principles, if only the markets had, in fact, ever used basic first principles for the more esoteric and more illiquid products that they were placing before investors. A focus upon the underlying assets that make up an asset-based security will, for instance, put the cash flow of the security in question under scrutiny. Market sentiment will have an important role to play in arriving at a justifiable valuation, as will input assumptions.

“In current market conditions, even a relatively minor change in assumptions relating to likely default levels for the underlying assets in a portfolio can have a dramatic impact on pricing,” says Jones.

Huge strides have already been made in the crucial area of standardising data on both sides of the Atlantic, with the European Securitisations Forum (ESF) RMBS Principles and the American Securitisation Forum (ASF) Project RESTART.

“The industry is working hard to sort itself out, and a lot of things are changing as the market is changing,” says Richard Clements, head of valuation risk at Thomson Reuters, who relishes the pricing challenges. “They make our pricing better and add colour from the street. Clients ask questions, we take a look at their arguments and maybe tweak our price. Every challenge makes our prices stronger.

“We are not making radical changes to our methodology but we are seeing new parameters and are moving with the market towards hand modelling the cash flows of individual securities to account for defaults and cram downs, taking all the facts into consideration when striking a valuation.”

If the tools exist to value assets more accurately, is it possible to argue that the mark-to-market process has been overdone and should be put to one side, as some financial institutions in Germany and elsewhere have done? “Mark to market is the worst of all approaches, except all the other ones that have been tried,”

As William Wellbelove, head of market and wholesale credit risk at KPMG puts it: “The key argument is that if you hold an asset to maturity in a perfectly-matched fund, cost accounting is probably fair. But if it is held against a repo, say, on an unmatched basis, it could be problematic.”