OTC Derivatives
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Study: Firms Turning to Third Parties for Derivative Valuations
October 6, 2008
The risks posed by incorrect pricing of derivatives are driving a fundamental shift in the marketplace, according to a survey from Vancouver-based OTC Valuations and the Professional Risk Managers International Association (PRMIA). Firms are increasingly turning to independent providers to gain greater insight into the models, methods and market data used to generate prices, says the report.
Results of the study, for which 433 individuals--including risk managers, regulators, consultants and vendors--from 77 countries were surveyed, indicate that "while most firms would prefer to have the valuation component in-house, realistically, in terms of infrastructure and technology, many are choosing to outsource that component," said Bob Sangha, managing director of OTC Valuations, a provider of valuation services for over-the-counter products. Wilmington, Del.-based PRMIA is a nonprofit association of risk management professionals in over 180 countries.
In the past, explained Sangha, a buy-side firm with OTC contracts would go to a counterparty such as a broker-dealer to get daily quotes. However, in the current credit crunch, firms are receiving stale prices because of the illiquidity of the instruments. "There is a real push for companies trying to value these derivatives to either determine the value themselves or get an independent party to value them," he said. "Mark-to-market no longer seems to be a valid approach for determining the value on a daily basis."
Only 5 percent of respondents were "very satisfied" with their current valuation solution, according to the study, which was issued Sept. 29. Reasons cited included inconsistent pricing methodologies, the need to use multiple valuation sources, inability to price the entire portfolio, and valuation and risk systems that are unable to keep pace with the growing diversity and complexity of derivatives products entering the market.
"With so many stating their dissatisfaction, it comes as no surprise that a majority of the respondents ... would consider a third-party valuation service vendor with derivatives coverage for vanilla and exotic derivatives," OTC Valuations said in a release. Among the vendor's clients are banks, asset management firms, hedge funds, fund administrators, custodians, treasuries and government agencies. Competitors in the space include SuperDerivatives, Markit Group and SunGard Data Systems' Reech.
Additionally, noted Sangha, institutions that invest in hedge funds are requesting independent valuations "because they want to ensure that hedge fund managers are not influencing fund administrators" in their calculations of net asset valuations, or NAV.
Despite such problems, "explosive growth" in the OTC derivatives sector is likely to continue, according to Boston-based research firm Celent. In a report released last month, Celent said that more growth is expected in exotic derivatives, spurred by the constant search for new, higher-margin instruments.
