04.05.2013
By Terry Flanagan

Pricing and Valuation Issues Surround Swaps

Pricing and valuation of complex derivatives is a major pain point for buy and sell side institutions, as regulations calling for greater transparency in the reporting of risky instruments get under way.

In Europe, the Emir regulation calls for centralized clearing of swaps via central counterparties (CCPs), and reporting to trade repositories.

As the scope of instruments which will be required to be cleared are yet to be determined by Esma, the European Union’s watchdog, and the national regulatory bodies, the exact scope of Emir is still unknown, said Anthony Belcher, head of pricing and reference data, EMEA at Interactive Data.

In the United States, the Commodity Futures Trading Commission has the broadest jurisdiction over a wide range of derivatives products under the Dodd-Frank rules. The Securities and Exchange Commission, on the other hand, primarily oversees what it terms “security-based swaps”, which includes single-name credit default swaps (CDSs) and credit default swaps based on a “narrow based security index”.

In July 2012, the two agencies agreed on basic definitions for “swaps” and “security-based swaps” among other things.

This set in motion certain trade reporting rules that were previously finalized by the CFTC although implementation of trade reporting requirements along with other related rules for market participants will be phased throughout this year.

“With regards to valuations, we are hearing some confusion from clients as to availability of pricing data once CCPs and trade repositories go live, which won’t happen until next year,” Belcher said. “They are unclear as to changes they need to make to polices and procedures as a result.”

There are also questions on which instruments will be required to be centrally cleared under Emir. “There could be situations where there’s differences among regulators, especially on single-name CDSs, where there tend to be large gaps in liquidity. Will they be centrally cleared, and if so, how robust will be the pricing?”

Independent third-party services that provide valuations with improved levels of transparency that detail key inputs offer a more robust approach – not only in the short term but also for the longer term – than a data feed from a CCP.

“Post-crisis, there has been a pronounced movement away from using counterparty marks for valuations of derivatives,” Belcher said. “Conflicts of interest can arise from using counterparty marks as a valuation.”

Credit and counterparty risk are critical issues for finance professionals, especially with many firms now facing new capital rules and requirements specifying how to benchmark investment portfolios and evaluate OTC-traded securities.

“One of the core components within an enterprise data management infrastructure is credit data,” said John Randles, chief executive of Bloomberg PolarLake, which centrally acquires, manages and distributes complex and wide-ranging financial data sets. “The focus in recent years has been on how databases can enable better risk management, reporting, and trade execution, which means having the ability to consolidate and make that data more easily consumable by applications and analysts. That is becoming more important across asset classes.”

Bloomberg Polarlake has added Fitch’s credit ratings data to its EDM managed service, providing financial institutions an independent and fundamental view of long-term credit risk.

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