Dealers May Need To Upgrade Valuation Services
Financial overhaul hits OTC
June 22, 2009
Securities dealers intending to keep big revenues via trading and structuring over-the-counter derivatives need to upgrade their valuation services to satisfy the market's demand for clearer views of risk and standard trading practices ahead of expected rulemaking in the sector, experts said last week.
That's the likely outcome of the financial reform proposal released last week by the Obama Administration when securities experts were asked how operation executives could best meet the calls for more transparency in the OTC derivatives market.
The analysts also said not to expect electronic trading of derivatives like credit default swaps (CDS) to occur anytime soon, despite regulatory plans that call for it. They said dealers are moving selectively, and were upgrading pricing systems to improve risk monitoring, versus porting the market to e-trading.
The administration's financial overhaul, outlined June 17, includes previous regulatory proposals, including moving OTC derivatives considered "standard" onto regulated exchanges and electronic platforms; mandating that such standard contracts be cleared; and having all OTC derivatives not cleared reported to a trade repository. Regulators and the industry have yet to specify what "standard" and "custom" will mean. The proposal must run through Congress and then the regulatory agencies before any rules are promulgated. Changes could be significant and may take awhile.
What firms can do now, analysts said, is bolster their derivative pricing models to make certain they don't pass along untrustworthy information. One way to do that is to feed the systems with more accurate--loan-level, for instance--data, and make it available in standardized formats to different business units. Doing so can better ensure a firm's survival in rocky markets by giving risk managers a quicker and more accurate view of complex exposures to underlying debt, thereby engendering a deeper, wider, and more precise picture of the overall credit risk a firm is taking.
If applied across the market, such upgraded valuation services may serve to better protect the overall financial system from daisy-chain calamity, which the OTC derivatives sector, through its interconnectedness and opaque nature, proved it can engender.
The key, experts say, will be in determining some base level of pricing mechanism for OTC derivatives, whether they trade heavily or not. That's because there are currently a slew of ways to price derivatives, with various outcomes. Setting accurate valuations is important not just for garnering initial pricing, but because those prices act as foundations that lead to a whole host of derivative determinants, including the level of collateral, margin and life cycle payments that must be made on the contracts.
To further streamline operations, firms should standardize their pricing analytics across disciplines with the goal of running a single platform for valuations. "We have seen a lot of efforts to make the pricing models consistent front-to-back," said Cubillas Ding, a London-based analyst for Celent. "The price models for OTC trades should be portable enough such that other divisions and functions can have the means to actually obtain updated prices for functions like risk control, collateral management, risk exposure and limits, monitoring these functions and activities.
"Price is a very fundamental element," Ding added. "I think that whatever flavor of standardization occurs regarding this whole topic of CCPs [central clearing counterparties] and having some of these OTC derivatives go on-exchange, there is a need to address how to standardize the valuation mechanisms, especially if models are involved, in order to make some of these so-called standard OTC derivatives price-able on an ongoing basis."
