OTC Valuation Services: How You Know If the Price is Right
Ever since the world’s first cross-currency swap was brokered by Salomon Brothers in 1981 between IBM and the World Bank, valuing OTC derivatives has continued to grow in complexity. The importance of accurate security and position valuation has moved in tandem with the increased adoption of more complex financial instruments. Just as art collection has spurred a new and very lucrative appraisal business, an entire industry has sprung up to support financial valuation needs.
The calls for greater transparency in OTC derivatives instruments have been loud and clear since the start of the credit crisis. Ultimately, understanding the value of these instruments will help develop better portfolio valuations and improved risk management policies. Finally, the regulators are acting.
The recently passed Dodd-Frank Act includes a number of provisions addressing the lack of transparency in the OTC derivatives markets. Regulators need better information on the holdings of major financial market participants, and anything that can assist in calculating more accurate valuations will go a long way toward addressing the problem. Not surprisingly, both buy- and sell-side participants want to have a better understanding of all of their counterparties’ financial conditions, and by extension, where they may have too much or too little exposure. To that end, the Dodd-Frank Act introduces a new independent agency with a strong mandate to enhance transparency across the industry: The Office of Financial Research (OFR).
The new regulatory environment will provide a significant boost to the prospects of independent valuation service providers. The regulators clearly want more openness in the markets, and on many different levels. Although final rules still need to be written, it is clear that the OTC markets will never be the same again. The introduction of swap execution facilities (SEF) and central clearing facilities will have a major impact on transparency, as price information can be expected to be more broadly available. This will force the valuation service providers to adapt and evolve their business models to cash in on the new opportunities or risk being left behind.
This evolving valuations ecosystem has resulted in many of the third-party software providers collaborating on analytics and pricing models. Whereas only a few years ago, these firms would viciously compete amongst each other for new business, there is now a greater willingness to collaborate and develop new solutions and services. The market data providers are also expanding into the valuation space with new offerings since the need for high quality market data will be a key differentiator as pricing models becomes more standardized.
Just like one shoe does not fit all, there are multiple types of valuation service providers. Each comes from a different angle or attempts to address different portions of the valuation market. The valuation business can be segmented into five major categories, although each may include overlapping segments as they look to expand: Accounting firms, Consulting/Niche Service Providers, Fund Administrators, Independent Software Vendors and Market Data Vendors. These types of firms all have their own strengths and weaknesses as they look for new opportunities whilst facing the new competitive landscape and threats.
As the pace of trading has accelerated, so has the need for faster access to data. Valuation providers are moving toward faster turnaround cycles in order to meet the demand from clients looking to accelerate analysis and trading decisions. This has resulted in much higher technical requirements for the provider’s infrastructure and availability, resulting in increased costs. Real- time valuations may not be a reality yet for all products, but the market is taking full advantage of technology innovation to help facilitate this goal. More simple instruments can be priced much faster and with greater accuracy since more transactions data will be reported from Swap Execution Facilities (SEF’s) that will greatly assist in their valuation.
The TABB Group Vision Note OTC Valuation Services: How You Know If the Price Is Right explores the current OTC Valuation Services ecosystem and challenges for the providers and how they are adapting their business to the new market conditions presented by the push from regulators with the Dodd-Frank Act. In particular, the report focuses on the five major categories of the valuation service providers, their strengths and weaknesses, and challenges that must be overcome to expand and make the most of the new opportunities.
- Fixed Income