Data Management at the Heart of Price Transparency and Risk Management
In a recent report, the Institute for International Finance’s (IIF) Committee on Market Best Practices said that in order to re-establish confidence in the market, the market needs to be assured that internal processes are always robust in terms of independent valuation and oversight, and that data and systems infrastructure exist to effectively support this..
The IIF suggests that to ensure consistent application of independent and rigorous valuation practices, financial institutions need to make use of all available modeling techniques and conduct regular review of independent price-verification procedures and sources. Price discovery for valuation purposes should be available through multiple channels. Among the measures IIF recommended for improvement are:
These are some of the basics of data management to which financial institutions need to return in order to achieve greater price transparency and improved risk management.
As became clear during the course of the last year, front office technology and product proliferation have run far ahead of middle office control and back office processing capabilities. Due to this processing and reporting lag, simply disclosing the value of portfolios – not just the current market liquidation value, but also an independent intrinsic valuation – turned out to be embarrassingly and painfully difficult. The accurate reporting of risk, in a time when market conventions were overturned, often turned out to be all but impossible.
Investors will no longer take prices at face value. It is critically important to put prices and quotes for financial products in perspective. The quoting party’s motives and ability to deliver will be scrutinised more. Users of the information need to ask: Who else is offering a quote? What is the spread? What are the volumes that are quoted? What are the venues where products can be traded?
While it is difficult at this stage to speculate on the regulatory impact, increased scrutiny on processing capabilities and information management can be expected. At present, the picture for the Asian economies is not overly gloomy. Compared to a decade ago, the Asian economies are far less dependent on foreign capital and countries have generally run budget surpluses the last few years. Recent events can only speed up the emergence of an already increasingly developed regulatory landscape.
In addition, economic growth in Asia has created a new class of investors who will be serviced by increasingly sophisticated local financial services industries. At the core of successful development of a financial services industry is a keen understanding of customer needs, connectivity to markets and product innovation, and integration of systems for better risk and solvency controls.
In general, financial institutions will have to prepare their data infrastructures for new risk management and reporting challenges. There will be greater demand for transparency and integration over risk and asset types, as well as the provenance of the information that drives it. Consolidation of banks will be another driver of consolidation of information infrastructure.
Recent events have taught tough lessons on the importance of independent price verification (IPV). A price control process can take different levels of sophistication, taking aspects such as execution venues, liquidity, known positions of market participants and collateral into account. FASB 157 on fair value accounting stipulates three approaches that can be used to revalue positions:
In the first approach, the focus of the pricing process will be on gathering observed market prices possible augmented with a valuation model. In the second, it will be on determining a product’s intrinsic value due to the forecasted cash flows as a function of a security’s terms and conditions. In the third valuation approach, the valuation focus will be on determining market depth as well as on observed prices. Regardless of the approach taken to value an asset, accurate financial markets data and a solid price verification process are needed in all cases.
Many investment managers and corporate treasuries have realised that they need:
1. IPV for prices on instruments to which they are exposed – whether complex financial products or simply plain vanilla interest and foreign exchange rates. This includes the selection of reliable sources, the cross-comparison and reconciliation between different suppliers and quality proofing of market rates. Instruments that cannot be priced or those with only a single supplier (that also markets the very same instrument) offering a rate should be brought to the attention of middle-office staff.
2. Better insight into funding options and credit quality. If a corporate is short cash, it needs to have security on (re)funding the business since access to funds has become more difficult. If a corporate is long cash, it will require a better overview of its credit exposure on banks where money has been deposited. Enabling this insight from an information management perspective includes deceptively simple things, such as cross references between different names or identifiers of institutions, but should also include insight into the legal structure of counterparties so that a complete picture of corporate structure and possible guarantees is possible. All too often’guarantee’ products have been taken at face value without consideration of the credit risk of the guarantor or supplier.
3. Complete overview and insight into securities and other financial products to which an institution is exposed. If excess cash is invested in fixed income products, more clarity is needed on the terms that define cash flows and credit risk. Again, only this transparency will allow for independent price and intrinsic value verification.
Whatever the regulatory and reporting outcome of the current banking crisis, it could be back to basics for the financial services industry for the near future, as accurate, detailed information has never seemed so valuable.
Market risk calculations require dependable high-quality data. Financial institutions need to be able to quickly manage growth of instrument types and data sources, meet business and time-to-market objectives, and provide flexibility for growth and local customisation to deliver end of day valuation, standardised pricing across portfolios, and benchmarking and liquidity analysis.
Financial services companies need to be able to control the tremendous volume of data flowing through their organisations and effectively transform that data into the insight they need to achieve greater price transparency and improved risk management. The key capabilities of data management solutions that can help organisations to achieve this contain the following:
Organisations need access to standard solutions that help take the risk out of their data management. Rather than placing efforts and precious resources into building quick fixes that would increase operational risk, companies should be focusing on putting in place modular solutions that enable their data management platforms to expand in coverage and functionality, as their institutional needs grow.