As the credit crisis continues to rock the U.S. economy, buy-side institutions that entered into OTC derivatives contracts with sell-side firms are taking steps to price the over-the-counter derivatives with independent, third-party sources. In the past, buy-side firms mainly obtained prices from their counterparties -- the investment banks that created the OTC derivatives instruments and calculated the prices with their own proprietary models.

"If I'm an investment banker creating these derivatives, who knows more [about them] than me?" says Paul Migliore, CEO of investment management consulting firm Citisoft North America. But since the broker-dealers often are on the opposite sides of these transactions -- and they stand to profit or lose money depending on the direction of the market -- relying on their calculations could pose a conflict of interest, he explains. "The big thing in the market is that no one trusts the dealers to price these instruments," Migliore adds.

Part of the problem is that OTC derivatives -- opaque, complex instruments that are linked to the movement of equities, interest rates, currencies and commodities -- are not traded on exchanges, so a true market price is hard to determine. Additionally, some derivatives are illiquid, making it even more difficult to value them. >>

Of course, as the credit crisis in subprime mortgages magnified and investors turned away from complex derivatives, including collateralized debt obligations (CDOs), dealers had an even harder time pricing them. Eventually, the dealers were forced to write down $150 billion in losses (as of press time) as a result.

Now the sell-side financial engineers and math whizzes responsible for valuing the OTC derivatives don't appear to be so smart. "Clearly, the sell-side has not done a good job of pricing these products," comments Michael Henry, the head of Accenture's financial services strategy practice in North America.

With uncertainty over how to price OTC derivatives roiling the entire fixed-income market, the buy side is seeking independent sources to validate The Street's bids and offers. "As a fund administrator, I need to find data points to come up with that valuation," explains Joseph Holman, founder and managing partner of Columbus Avenue Consulting, a hedge fund administrator based in New York with $6.5 billion in assets under administration.

"A market price, or any price, has to be observed; and to be observed, someone has to transact," Holman continues. "In the credit markets, where there's talk of a lack of liquidity, people aren't buying anything, and that affects valuations."

While mutual funds and hedge funds have been moving toward independent valuations of OTC derivatives for the past few years, the credit crisis has accelerated the search for neutral third parties to calculate and sign off on derivatives prices. "The CDO market environment was a wake-up call for the entire financial services industry," comments Judson Baker, derivatives product manager at Chicago-based Northern Trust, which offers an asset-pricing service for listed and OTC derivatives.