Derivatives: under pressure

Derivative instruments have featured consistently in the headlines since the financial crisis began, in many ways placed at the heart of the meltdown. But while trading volumes have suffered as a result of the depressed market, demand for independent valuation of over-the-counter (OTC) derivatives has undergone a massive increase.

There have been several reasons behind this upswing. One of the most pressing is new rigour towards risk management procedures, which means that investors are not willing to simply trust the counterparty price alone any more, preferring an objective measure.

“After the market turmoil, asset managers realised that it was necessary to have a more independent valuation provided than that from the investment bank supplying the derivatives,” said RBC Dexia, director of alternative investments, Olivier Laurent. “Now they outsource these valuations specifically to the fund administrators.”

Equally, financial regulators have shone a light on the industry, and in several cases are now asking for a third party valuation.

Among others, the French Insurance regulator l’Autorité de Contrôle des Assurances et des Mutuelles, imposed an obligation to source independent valuations of derivatives on market participants in 2009. This was a move echoed across Europe, in both Portugal and Italy. 

“In Europe, you see this happening not only with fund managers, but also with pension and insurance sectors,” said Société Générale Securities Services (SGSS), head of asset servicing, Philippe Rozental. It has recently won several new mandates from institutional investors for valuation of OTC derivatives including the British Telecom pension fund in the UK, Ireland’s tarnished asset programme, Ilmarinen, and French personal insurer CNB. 

One vision

Fund administrators can deal with this area of the business in one of two ways: build the technology to process valuations in-house, or outsource it to one or more valuation houses themselves. With a few exceptions, where more than a handful of simple instruments require valuation, outsourcing has been the principal choice. Derivatives valuation can be a complex, multi-layered and costly business. Especially in the current climate, administrators do not have the resources to invest in the additional technology needed to cope with the business. 

“We have had many requests from large pension funds and fund managers because their administrators were not able to provide an independent price,” said SGSS’s Rozental. It offers independent OTC derivatives and structured products valuation as a standalone service.

Typically, the decision to outsource comes when administrators or custodians have to deal with either a large number of derivatives products or very complex instruments. One of the main problems for administrators is the technological requirements needed to build a scaleable engine for pricing.

“The real challenge is to put in place an industrial process around the valuation of these products,” said Pascal Scatozza, global client solutions, fund administration and middle office outsourcing at BNP Paribas Securities Services. “We have to calculate independent prices on a daily basis, early in the morning in order to meet our clients’ Nav calculation needs... Anybody can price an interest rate swap, but not everybody can value 2,000 interest rate swaps in one hour.”

Ucits funds are increasingly using derivatives to achieve their objectives too, as regulatory criteria permit. Funds are also coming to deal with more complicated derivatives, especially hedge funds strategies with the Ucits stamp which permits the use of derivatives, so-called “newcits funds.”

“We are seeing more and more funds trading contracts for difference (CFDs), and this has started to become very complicated – first we had CFDs on equities, now we’re starting to get CFDs on bonds, as well as on indices. Virtually all the structures put into Ucits are done via total return swaps so that’s obviously driving OTC derivatives use,” said RBC Dexia’s Laurent.

“We need to have, as administrators, an alternative process for managing a high volume of trades on OTC derivatives because we have so many hedge funds using CFDs rather than just equities, which is fairly new.”

What complicates this further is that producing a number is only half the story. Clients are now increasingly prescriptive about how they want the information presented to them, and the transparency of the process by which prices are produced.

Play the game

One of the issues that can arise, and indeed the reason for sourcing a third party valuation, is the price not matching the counterparty’s quote. In this case, the valuation house will need to reconcile the two prices, and analyse from where the discrepancy has arisen.

“There’s a greater call for administrators to be able to talk one on one with investors if for example there’s what we call a price challenge,” said Roger Boyd, senior vice president at Citi, who runs the Complex Pricing department.

“If we see a large price difference, then we are in a position to reverse engineer to display where a difference is coming from. Ninety percent of the time it is due to market data.” 

This is a particular issue at the moment because investors are less likely to trust the price which has been offered by the counterparty. “Being able to reconcile the independent valuation with the counterparty price has become really key in the past year,” said SGSS’s Rozental.

Fund managers in many cases were using the counterparty valuation, especially internally, and this is risky because they do not have the capacity to justify the prices, moreover it may happen that errors occur with the counterparty pricing.”

BNP’s Scatozza said it is a case of opening a dialogue with the client when prices do not match. “You try to pass on as much data as you can to explain how the price has been made, then it is the client who will decide which is the price to be used. We can explain to the clients which market data we have used and the credibility of the price we have offered.” 

As a result, the “black box” techniques of previous years are now outmoded, as clients demand transparency. “Because of the requirements of the regulator, clients are increasingly asking for transparency on how the prices are computed,” said Scatozza.

This is another element which is making the process more demanding for both administrators and custodians. 

“The most interesting aspect [of the business] I’ve seen in the past six to nine months is for transparency of the valuation,” said Gavin Lee, chief operating officer of SunGard’s FastVal and Monis tools. Subsequently, it stocks a white paper online available to clients for every pricing model it uses, as well as offering access to details of the individual data points that were fed into the model. “That has become almost an absolute requirement now for most of the people we deal with... it is no longer acceptable to just say the price.”

As a result, even when fund administrators are outsourcing the majority of this work, they are taking people on board who are able to deal with this information. “Until recently you could just send a file of data and that was fine, but now a lot of administrators and servicing organisations are looking to have that as part of the process... they want to receive it and process it electronically, so we spent a lot of time and effort in creating application program interfaces (APIs) that can link into our services,” said Lee.

He explained that this has become a statutory requirement in the past couple of years, both from a client and business perspective.

Another key shift following the financial crisis that he highlighted is the increase in frequency of valuations. “At first [fund administrators] were looking for valuations every month, gradually that’s changed to daily in some circumstances, or at least on a weekly basis.” He added that the increased requirements overall in this business for fund administrators mean that “the cost is undoubtedly higher.”

Breakthrough

The unpredictability and severity of market movements during the financial crisis led to calls for significantly more frequent production of Navs for appropriate collateral management. This added further to the workload and costs for service providers, which limited its adoption. 

“About a year ago, everyone thought we were going to have to be valuing every instrument on a daily basis, but it was only a moot point because no-one was ever prepared to pay for that. If a fund is monthly, we value the instruments monthly, if it’s weekly then we’ll do that, so the trend towards daily valuation did not materialise to the extent initially envisaged.” said Citi’s Boyd.

Boyd believes the most important future trend in the business will be automation. This will greatly reduce the instances of human error, and provide more efficient Nav turnaround, facilitated by the benefits of straight through processing. Citi currently has a project underway to move the entirety of its valuation onto an automated platform.

“That is the challenge everyone is facing, and it is not easy,” he said, estimating that less than 10% of traded OTCs are currently processed automatically. “To automate it requires a lot of investment…my objective for this year is just to automate the credit and interest rate products that we deal with on this desk, and that takes a lot of IT support, due diligence and data mapping.” This is despite the fact that interest rate and credit products are some of the easiest to process as the parameters are much more standardised.