News Analysis

Transparency conundrum

Thursday 25 September 2014 12:16 London/ 07.16 New York/ 20.16 Tokyo

IPV best practices surveyed

The majority of independent price verification (IPV) and valuation professionals polled by SCI, in partnership with Fitch Solutions, use multiple data sources for verification processes and reserving methodologies when valuing CDS. However, different approaches to consensus pricing suggest that an industry standard is yet to evolve.

A dominant theme revealed by the SCI/Fitch Solutions 2014 CDS IPV Survey is the continued importance of transparency in CDS pricing data (the full survey results can be downloaded here). At the same time, however, the survey also exposed unwillingness from many banks to disclose their CDS pricing data due to litigation fears and damages stemming from the Libor scandal.

"I think all banks undertook a review of the submissions they make following the Libor scandal - consensus-driven or anything else," says one survey respondent. "I believe a lot of banks now shy away from giving information to these sorts of services, and I think there are fewer submissions as a result."

There are differing internal policies at banks in terms of the internal department that owns the responsibility to contribute - or not - to consensus pricing. In some instances, the decision resides with the valuations or compliance departments. In other institutions, the more extreme examples show that responsibility lies solely with the front office.

"Banks are seeking reassurance from vendors around the scrutiny and data cleaning of submitted data through increasing due diligence on vendor processes and enhanced documentation," says Diana Allmendinger, director of CDS pricing and analytics at Fitch Solutions. "This gives banks some level of comfort with the data submission process, but even then the nervousness remains. Where this is the case, there is little we can do to combat the banks' reticence other than try to meet with the decision-makers and educate them about the importance of submitting and receiving CDS consensus pricing."

Allmendinger also suggests that regulators could issue a directive to encourage banks to cooperate, but adds that all of these avenues currently prove challenging. While offering more transparency for regulators, submitting pricing data to trade repositories is not akin to - nor a replacement for - consensus pricing services, as banks do not receive data back to use in their IPV processes.

IPV desks use multiple data sources for the prudent valuation of CDS, including trade, executable, consensus vendor and clearing house prices, as well as quote vendors. Survey respondents utilise a hierarchy of pricing sources, with trade data tending to appear at the top of most lists. Proxy pricing and modelled prices tended to be used as a last resort where no other data is available.

With so many pricing options available to IPV desks, the survey highlights a potential need to be able to view multiple pricing sources simultaneously. This would be particularly useful if a firm's typical first port of call was not always going to be the most reliable.

The importance of multiple pricing sources was also underlined by the fact that pricing data is not always available for certain securities. CDS with very long or very short tenors, as well as illiquid or distressed names were often cited as 'black spots' for accurate data.

"We see gaps in illiquid areas or distressed names," says one valuation head. "However, we have so many data sources that if they are missing from one area we can usually find a price from a different source."

Data quality, granularity, transparency, coverage, the price of the service and ease of use were all cited as important factors when IPV teams select their primary pricing sources, according to the survey. One respondent commented that his institution's process focused on 'minimal valuation uncertainty and maximum transparency' around the assumptions or prices used.

"When we do our IPV process, we also look at the uncertainty within the IPV process," he explains. "If we are given an independent price, we have to look at how happy we are with that independent price. The best independent prices are those that are closest to the executable price, where the prices are reflective of trading levels."

Meanwhile, attitudes to data vendors' services appear fairly positive, based on survey responses. The majority of respondents were satisfied with the vendors' approach/methodology in collecting and aggregating CDS pricing, with just a small number requiring more transparency. The majority of respondents were also happy with the quality and presentation of data provided by vendors, with a minority seeking further clarity or clarification to vendors' data.

Among suggestions for improvement was a request for better interfaces, a need for a standardised automated format for emails or delivery method, and for standard deviation data to be used in prudential valuation calculations. "Vendors have been making a lot of progress to deal with the prudent valuations directive and the whole space is in flux as to what people want from their data providers on that front," comments one UK IPV head. "But generally speaking, I don't need any more data."

The financial crisis and ensuing regulatory changes have, inevitably, had an impact on IPV teams and their processes. For example, one respondent noted that their IPV department did not formally exist before the crisis, while another commented that organisational changes had resulted in a more influential role for the IPV team within their firm.

"In the past, it used to come down to who was more thick-skinned - the traders or the IPV team," comments one IPV head. "But due to organisational changes, the P&L, product control and risk sections are now working together. While the trader does have some input into the valuations process, it is now our say at the end of the day."

Audit - both internal and external - is also impacting pricing and validation processes. Survey respondents indicated that auditors request clarification on pricing of certain securities and demand transparency in both generating IPV data and the process by which it is reached. In several cases, respondents commented that auditors may challenge their data vendor choice.

For a question-by-question analysis of responses to the SCI/Fitch Solutions 2014 CDS IPV Survey, download the full PDF. SCI interviewed over 25 IPV and valuation heads from financial institutions in Europe, the US and Asia.

25/09/2014 12:16:09