Towards Transparent Pricing

Like other aspects of the financial industry, pricing and valuations is currently the focus of significant regulatory change, with scrutiny of pricing methodologies, input data and confidence levels all increasing. When a group of experts in the field took part in a panel discussion at the European Financial Information Summit (EFIS) in London, in September, it was therefore inevitable that they would quickly turn their attention to the impact of new regulations.

The top measures affecting pricing and valuations are the Alternative Investment Fund Managers Directive (AIFMD) and International Financial Reporting Standard 13 (IFRS 13). AIFMD is a European Union directive that is intended to harmonize the way alternative investment funds-including hedge funds, private equity funds and real estate funds -operate, improve competition and protect investors. AIFMD puts great emphasis on transparency, requiring alternative investment fund managers to report to regulators and investors on their assets under management, asset types, leverage, risk and liquidity.

Independent Valuations

Most relevant to the panellists at EFIS is the fact that AIFMD requires alternative investment fund managers to use independent valuations and create policies and procedures that outline how valuation processes should operate. If an alternative investment fund manager uses a third-party pricing provider, it must set out a procedure that will ensure the pricing provider receives all the information it needs to accurately calculate the valuation. If the fund manager decides to do the valuation internally, its policies must include safeguards that ensure the independence of the valuation.

Anthony O'Connor, HSBC's Dublin-based head of product management, OTC pricing and risk, global product, explained the directive means fund managers must perform more rigorous due diligence on pricing vendors they use. "Due diligence can often be light touch, but the directive now is pretty explicit that you should perform reviews of the skill sets of the people who are employed at the vendor. Make sure they are not a fly-by-night company. Make sure they have significant financial support [...] All of those certainly need to be examined from a due diligence perspective."

AIFMD means pricing vendors have to provide more information about the inputs into their calculations. "Obviously, there is an understanding that there are certain elements of proprietary data or secret recipes that vendors may or may not want to disclose, but there is increasing pressure for vendors to open their books a little bit more to show where they are getting the data, what kind of scrubbing is going on, and what kind of adjustments are being made to the data," said O'Connor.

Hard To Price

Gary Pringle, Edinburgh-based vice-president at JP Morgan Corporate and Investment Bank, pointed out that the underlying data required is often difficult to access. "Certainly investments that fall within this directive and are managed through the alternative investment funds are very bespoke. It is not easy to access that underlying data or information," said Pringle (who emphasized that he was expressing his own views on the topic, rather than those of his employer).

Jayme Fagas, New York-based global head of evaluated pricing at data and pricing vendor Thomson Reuters, said vendors must address the paucity of data for hard-to-price assets. "As a minimum, we have to prepare and ramp up our coverage," said Fagas. "Vendors need to offer as wide an array of coverage as possible so we can meet the needs of some of these not-so-known investments."

Fagas said pricing vendors must help their customers satisfy the due diligence requirements of AIFMD. "We as vendors have to make ourselves available for due diligence meetings, because that allows clients to be comfortable with our practices and methodologies. It adds transparency at a high level," said Fagas. "But we also have to show how we make our methodologies and [we have to make] the data we use available and transparent [...] We just have to get more specific, more transparent and have a better range of coverage."

Fair-Value Hierarchy

IFRS 13 is a new accounting standard that was introduced at the beginning of the year to ensure consistency with the Topic 820 standard used in the US. IFRS 13 requires reporting entities to categorize their assets and liabilities according to a three-tier fair-value hierarchy and to provide different levels of disclosure depending on which category they fall under.

To correctly classify their assets and liabilities, entities need to understand the inputs that were used when valuing them. The entities must also be familiar with the processes and controls of the pricing vendors they contract with. For example, if a pricing vendor used unobservable data in a valuation, the input into the standard belongs to level three of the fair-value hierarchy and the entity must make detailed disclosures about the relevant asset or liability. However, if quoted prices for identical assets or liabilities in active markets were available to the vendor, the input into the standard belongs to level one of the fair-value hierarchy and the disclosure requirements are less onerous.

O'Connor explained that it can be particularly challenging to categorize the inputs used for over-the-counter derivatives pricing. "If you are looking at a product like an equity option, you may be reliant on historical volatility because of the term structure of the deal you are trying to price," said O'Connor. "In that case, that input is a level three input. But if you have client volatilities, for instance, on the products you are trying to price, then it is a level two input. So even an option or an interest rate swap can move between level two and level three, or level one for that matter."

Scrubbed Prices

O'Connor said firms such as HSBC can help their clients comply with IFRS 13 by validating prices they receive from vendors. "For our clients, [we can help by] making sure they do know where a price has come from, which vendor has provided it, but also by showing we have done a check on the price -what I like to call evidence of checks," said O'Connor. "You are sort of saying, ‘Yes, this has been checked, this is a scrubbed or clean price and we know we can stand over it.'"

O'Connor pointed out that IFRS 13 also puts an emphasis on the importance of narrative and qualitative descriptions of uncertainty surrounding valuations, which do not always come naturally to people who work in valuations. "Unfortunately, when we are dealing with a complex asset, we can't just stick a number on it and say this describes the confidence level we have in this price," said O'Connor. "It is not that straightforward. [...] Free-form qualitative descriptions are certainly something we are going to have to be more prepared to provide."

Market Color

As well as providing the assumptive data used in their valuations, Fagas explained that pricing vendors must help their clients comply with IFRS 13 by capturing market color and making it available. "It is no longer just about what the price recipe is, what assumptions were used and so on," said Fagas. "It is what trades, what quotes, what other market data did you reference? We need to capture that and deliver it. Some of that is not easy to fit it into a box in a database. There could be free-form elements to what we are trying to convey."

Fagas said Thomson Reuters plans to provide more market color to its customers, but explained this can be a difficult task, especially when dealing with hard-to-value asset classes that are not traded frequently.

There are still many questions to be answered about the impact regulations will have on valuations and pricing. O'Connor said he is interested to see how the introduction of central counterparties (CCPs) for the clearing and settlement of OTC derivatives trades in Europe will affect pricing. "There is going to be a good bit of responsibility on the CCPs to have a certain level of transparency there, to be open and clear about the models they are using and be willing to share that pricing beyond the clearing broker and the client, in that case," he said.

Over the coming year, the full impact of new regulations on pricing and valuations is likely to become clearer-creating plenty more to talk about at EFIS 2014.