Embracing Transparency: Technology as a Solution
With the current financial crisis, corporate treasuries are required to increase the transparency and clarity of their financial reporting and financial reporting processes. These changes are mandated through various financial accounting standards, such as IAS 39, FAS 133, FAS 157, and CICA section 3865, or regulations such as Sarbanes-Oxley. Although the need for compliance is widely discussed, these regulations are not prescriptive as to how to comply, and many corporate treasurers are wondering if technology can be part of the solution. Most are discovering that derivative valuation and risk measurement software or services can play a cost effective role in addressing their concerns of transparency.
In addition to reducing effort and cost to comply with these regulations, transparency can also provide information required to enhance risk management best practices. The same need for fair, independent and transparent visibility into the models, data and analytics required for transparency is crucial for successful risk measurement. Systemised transparency, as part of the valuation process, lends itself to better compliance and stands firm under the scrutiny of audit. Furthermore, the information on valuations and risk measurements provides valuable information that can enhance real business performance and even competitive advantage.
Corporate transparency reflects the idea that the more information that is disclosed about organisational activities in a more timely fashion to a wider public, the better. No matter how we define it, the fundamentals are clear – transparency requires a level of openness and visibility – whether related to a firm’s financial statements or its business practices.
The notion of transparency has been around for as long as corporations have existed, so why is it now top of mind? In today’s illiquid and volatile markets, it is no shock that there’s a greater push for increased transparency, particularly because not all organisations have embraced transparency in all its forms.
In 2002, after the demise of Enron and Worldcom, the US government passed the Sarbanes-Oxley Act. This piece of legislation significantly improved organisations’ corporate governance and accountability, particularly with respect to their financial statements. The Act requires companies to follow a more rigorous process in their accounting practices and instilled stricter controls over their financial reporting. While this has significantly improved investor confidence, the transparency disconcert is occurring once again, this time related to a number of factors including valuation of derivatives and risk.
Many of the discussions in the past several years have centred on the issue of derivatives, those instruments that some have labeled as the financial ‘weapons of mass destruction’. The issue at hand is not derivatives themselves but rather the way in which they are used and valued. The questions investors and regulators should be asking relate to how such instruments are valued:
It is this kind of knowledge and insight that lends itself to the new era of transparency and the beginnings of a second wave of regulations.
On 12 February 2009, the House Agriculture Committee approved legislation to increase the transparency and strengthen oversight of futures, options and over-the-counter (OTC) markets. The Committee approved the Derivatives Markets Transparency and Accountability Act of 2009. The legislation, H.R. 977, is designed to bring greater transparency and oversight to futures and OTC derivatives markets. Further, on 17 March 2009, the FASB issued a news release announcing its intentions to provide additional application guidance regarding fair value measurements and impairments of securities. One of the FASB’s proposed staff positions (FSPs), FAS 157-e ‘Determining Whether a Market is Not Active and a Transaction is Not Distressed’, provides guidelines for making fair value measurements more consistent with the principles presented in FASB Statement No. 157 Fair Value Measurements.
While it remains to be seen how these new regulations will take effect, what they appear to be doing is seeking a common language that all stakeholders can agree on – government, regulatory boards, auditors, corporations, banks and other financial institutions, and investors. This common language needs to be able to deal with the complexity of the financial marketplace. It needs to be proven, documented and clear. It also needs to permit audit review or replication on demand.
To regain investor confidence and trust, corporations, banks and other financial institutions need to fully embrace transparency. This means disclosing all the facts about their financial transactions, listing all underlying assumptions and describing all relevant parameters and models used with clarity and without any confusion or guess work. A good starting point will be leveraging the advances made in derivatives valuation and risk technology. Many corporate treasurers and risk managers are discovering that derivatives valuation and risk measurement software can help address the new era of transparency and help with compliance and risk measurement.
Regulators require clear and accurate visibility into valuations and shareholders want reassurance through third party independent pricing. As a result, many organisations are now using third party valuation solutions to support their existing valuation process either to fill gaps in their systems or to obtain a secondary check against counterparty or broker quotes. Organisations need to have the ability to quickly replicate and benchmark their calculations from an explicit documentation of the implemented mathematical models.
There are a number of factors to consider when choosing valuation and risk measurement software:
Black box solutions are not acceptable from a transparency or risk control perspective. Providing complete transparency with comprehensive documentation and ability to view calculation methodology, formulas and examples of every function are needed. This allows users and auditors to verify and validate each and every part of a valuation.
Sourcing and managing a high quality source of market data is one more headache that can be prevented by outsourcing to proven vendors. This also provides a side benefit of reducing the associated with having the source of your data questioned. Proper tools and procedures in place before valuations or disclosures are challenged, and for ongoing monitoring of positions, is a prescription for operational stability. 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.
Simply having the valuation software is not enough. Ensuring that the vendor has the market expertise and industry experience to back up its offering with the ability to address your questions and advise you accordingly.
Through recent market events the valuation concerns of regulators and investors have been verified, highlighting the need to adopt independent and transparent valuation processes. Corporate treasurers are looking for cost effective ways, including using technology, to address the regulatory compliance and risk measurement needs of their organisations. To ensure this, the technology used needs to be transparent by providing full documentation through disclosing the models, parameters, methodologies, and references used to perform valuations. Using consistent valuation processes and a reliable, supply of market data, preferably from the same vendor, can be the ounce of prevention that saves many downstream headaches.