Asset managers that enter into over-the-counter (OTC) derivatives contracts and structured products with sell-side trading desks are demanding independent valuation services from their custodians, according to several sources. In response to scrutiny from institutional investors, compliance officers and risk managers, as well as internal boards of directors, investment managers are taking a keen interest in how these complex instruments are priced.
On the buy side, hedge funds that invest in derivatives through prime brokers are outsourcing valuation services to fund administrators to provide an independent price to investors. "As you have more strategies that don't rely on exchange-traded instruments with illiquid OTC products, do you want to rely on [prime] brokers or hedge funds for valuations?" asked Brad Bailey, senior analyst at Aite Group, at a roundtable in December on operational risk sponsored by IPC and Eze Castle. "Investors want to rely on an independent third party, especially where there's a lot of wiggle room on the valuation," he added.
In the past, an asset manager that purchased a structured note combining equity and fixed-income components typically relied on the dealer for the price. But that is changing.
"The regulators are cracking down on that, saying, 'You guys really need an independent source of valuation,'" according to Vall Herard, SVP of product marketing at NumeriX, a developer of analytic models for risk management and pricing OTC derivatives. Herard compares the situation to a consumer who relies on a used car salesman to determine the value of a car rather than looking it up in Kelly's Blue Book. "That is not a smart thing to do," he says.
Understanding Underlying Risk Similarly, if a pension fund has hired an investment manager that is taking positions in structured products, the investor needs to understand the underlying risk, Herard continues. "At the end of the day, people need some level of transparency in terms of what is the risk that the structured products really represent," he says.
With asset managers holding increasing amounts of credit derivatives and interest-rate swaps in their portfolios, custodians that value the portfolios for pension fund clients are starting to offer OTC derivative valuation services for their institutional clients. For example, in January, Mellon Financial Corp. and Northern Trust, two of the largest custodians, both announced they were offering independent, OTC derivative valuation services through relationships with third-party vendors.
"We're offering a service to institutional clients due to the fact that obviously there is increasing growth year over year in OTC derivatives," says Patrick Ludden, product manager with Mellon Asset Servicing Group in Boston. "This is part of a service that institutional clients are asking their service providers to provide."
Corporate pension plans, endowments and foundations are asking for this type of service either because they hired an external manager that holds OTC derivatives, or they manage money internally and go to a prime broker directly to execute these deals, Ludden explains. "That's why you're seeing a change in the regulatory climate, and you're seeing your risk and compliance folks probably ask tougher questions around these instruments," he suggests. "The end client is requesting this as an independent source."
Mellon began providing the service in late 2004, initially focusing on the most common instruments -- interest rate and credit default swaps, according to Ludden. Now the service "is pretty broad" and has the ability to price options, including both index options and equity options, as well as total return swaps, credit baskets and currency swaps, he adds. Ludden notes that Mellon contracted with several vendors for the service, but he declines to name them.
The More Sources, the Merrier
On Jan. 9, Chicago-based Northern Trust announced that it selected SuperDerivatives SD Revaluation as an independent service for pricing the foreign currency, interest rate and equity derivatives portfolios it manages for its clients. SuperDerivatives has been valuing currency options for Northern Trust for the past year and a half, according to Michael Muller, senior business processing analyst at Northern Trust. Now, he adds, the bank is expanding the relationship to include interest rate swaps, to be followed by equity options.
Currently, Northern Trust is developing the interface and the file format with which it will share interest rate derivatives data with SuperDerivatives. Muller expects the interest rate derivatives interface, as well as the interface for equity options, to go live in February. "We've tested with them, and they have the capability to do it," Muller says.
However, Northern Trust isn't relying solely on SuperDerivatives. It works with two other pricing vendors as well -- Markit Group and Bear Stearns Direct, a separate pricing valuation business of Bear Stearns. "Our goal is to always have more than one price per asset," explains Muller. "It just gives us another quality check on our price."
According to Muller, here's how the process works: First, the investment manager sends the details of the trade to the custodian, Northern Trust, which enters the information into its system. Then Northern Trust creates a file of those terms to send to the vendors, which value the trades and send them back to Northern Trust.
When the prices come back into Northern Trust's system, "It allows us to scrub the price and compare the prices to one another. If there are outstanding prices that don't fall within a certain tolerance of each other, it alerts us that there is a discrepancy," explains Muller. For example, "If a price triples or quadruples it will set off an alert in our system."
Having multiple data vendors also helps solve coverage problems in case one vendor doesn't cover a certain OTC derivative, Muller adds, noting that SuperDerivatives covers interest rates, FX and OTC equity derivatives; while Markit Group and Bear Stearns Direct both provide prices on interest rate swaps, credit default swaps, asset-backed credit default swaps and credit default indices. "We try to take a best-of-breed approach by using the three of them," he emphasizes.
Before selecting an independent pricing service, Northern Trust spoke with the vendors to gain an understanding of how their models work and verify the accuracy of their derivatives pricing, Muller relates. "We make sure that each vendor uses market-standard prices to value the instruments," he says. "There are multiple ways you can value OTC assets, but there's kind of a market convention."
Further, Muller explains, custodians such as Northern Trust want the vendors to schedule the pricing at certain times of the day. "We want to be able to send a file as late in the day as possible, which allows us to capture more of the trading, and get the [priced] file early enough to meet certain cutoff times," he says.
Because OTC derivatives are growing exponentially and clients are demanding the pricing service, custodians must automate the process to handle the increasing volume. For example, in 2005 Northern Trust priced 1,200 OTC assets a day; by 2006 it priced about 3,200 a day, according to Muller. "All of this gets automated," he stresses. But automating OTC derivatives pricing is dependent on getting the complete terms from the investment managers, adds Muller.
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio