Advantages of Integrated Market Data with Derivative Analytics
At first glance, market data appears to be a simple and rather dull subject to examine. However, there are good reasons to examine the downstream impacts and reasoning behind finding a reliable source of market data that fits a firm’s operational, reporting and decision support needs.
Market data is an input to measuring fair values, reporting on hedges and marking derivatives to market. Of the many possible usages of market data, these three stand out in the current environment:
Key advantages to outsourcing the provision of market data for valuation purposes include:
Where valuations rely on pushing data through models or using simulation methods, such as Monte Carlo analysis, there is high value in sourcing both the analytics and the market data from a single vendor. Aside from the obvious uniform support benefits (problems with either part can be escalated through a single communication point, or at least through a single vendor), technical integration issues can weigh in to complicate matters where data comes from one source and analytics come from another. These issues can precipitate operational risks that aren’t obvious until exception scenarios occur. Determining whether to fix source data when the real issue could be the valuation model is a daunting prospect to say the least.
In a similar way that banks provide private balance and transaction data through Bank Administration Institute Version 2 (BAI2) formatted files, providers of market quotation data marshal significant behind-the-scenes infrastructure and effort to present market data products for final consumption. In the case of BAI2 data, this implicitly includes the basics of balances and transactions, but can be a taller order when it comes to providing overnight investment sweep returns or zero-balance account (ZBA) offsets in the same file. In a similar vein, market data required for valuation of OTC derivatives implies the basics (bid-ask or mid-market quotes, and perhaps volatility surfaces where needed) and more detailed data where it provides value, so one size doesn’t fit all.
While there is much value-add behind the scenes in cleansing, standardising, storing and deploying market data – good reasons in themselves to outsource – there is equal value in distinguishing between necessary market data and overkill market data. For example, preparing a derivatives portfolio for audit readiness entails uncovering historical quotation data, but not necessarily on a real-time basis. It would be incredibly cost-inefficient to pay for real-time quotations where reliable snapshots or end-of-day data would suffice. This is especially true where reporting is infrequent, for example, on a quarterly basis as with hedge effectiveness reporting. Because of the enormous infrastructure cost implied in storing all real-time data throughout the relevant history, the product price would correspond. End-of-day data is not only a viable alternative here, but could be a better fit when matching needs to a cost-effective solution.
Using consistent valuation processes and a reliable, consistent supplier of market data, preferably from the same vendor, can be the ounce of prevention that saves many downstream headaches. For example, because fair value measurements and hedge accounting have diverse income statement and balance sheet consequences downstream (where derivative valuations become accounting entries), it is instrumental to recognise that reliable, consistent sources of market data upstream, together with integrated analytics, goes a long way towards preventing misstatements and restatement risk. This is especially true where valuations rely on models or simulation.
Suppose a company has converted fixed-rate debt into floating rate debt using plain-vanilla interest-rate swaps where it receives fixed and pays floating. Effectively, a new exposure position has been created that could add volatility to portfolio values if, for example, the Fed decided to raise interest rates. Of concern are both the potential balance sheet and income statement effects of a wide movement.
Under such a scenario, especially if interest rates were to increase rapidly over a short horizon, scrutiny of derivative positions and their fair values could increase internally and externally. Regardless of whether such increased scrutiny is driven by a displacement of the original strategy behind seeking fixed-rate financing, or its conversion to floating, the process of fairly valuing the derivative could come into question. A consistent, independent and operationally transparent source of market data and integrated analytics upstream can be a formidable resource for demonstrating proper inputs and procedures under scrutiny.
In an environment where historical profitability patterns are seeing aberrations, the share of profits and losses attributable to mark-to-market changes, asset reclassifications, hedge ineffectiveness and derivatives not designated as hedges rises in significance. Balance sheet and income statement effects can impact a company’s debt ratings, and therefore total liquidity and cost of capital. Sourcing and integrating reliable market data into financial systems upstream can therefore impact both the quality of disclosures and actual access to capital.
Getting the basics right goes a long way towards avoiding downstream reporting and compliance issues. The potential for restatement risk, lack of comparability, and decreased quality of disclosure due to inconsistency of valuation process or misapplication of accounting rules is becoming a significant business consideration. Having the quality of one’s market data questioned is one more headache that can be prevented by outsourcing to proven vendors. Having good tools and procedures in place before valuations or disclosures are challenged, and for ongoing monitoring of positions, is a prescription for operational stability on at least this one dimension. Implicitly, the value of good market data can impact cash management and the oversight of the permanent part of working capital and, therefore, the responsiveness of treasury to changing economic conditions relative to the entire treasury portfolio.
With the potential to impress or upset the entire strategic thrust of an operating year through financial statement and portfolio impacts, the benefits of following instrument values closely, monitoring them on a portfolio basis and analysing the scenario implications of taking action all rely on good market data, good valuations and, ultimately, transparency and consistency of process.
Market data doesn’t seem so dull after all.