Regulators Step Up Scrutiny Of Pricing Services

Terry Flanagan

Providers of evaluated pricing services and their customers are facing increased scrutiny from regulators, which is triggering calls for greater transparency into the pricing methodologies used.

Evaluated security pricing services provide computer-driven or manually calculated prices for illiquid and over-the-counter securities, such as asset-backed securities, mortgage-backed securities and collateralized mortgage obligations.

“Regulators have been quite vocal around evaluated pricing and reference data, and they have made their concerns known,” said Jayme Fagas, head of evaluated pricing at Thomson Reuters, a data vendor.

Regulators are requiring auditors and end users to do more work in validating the use of third party pricing vendors in determining fair values for financial instruments.

“Regulators want end users to take deeper dives into pricing vendors’ operations and methodologies to ensure reliance on evaluated pricing and reference data is validated,” said Fagas. “Effectively, the regulators’ recent comments are a call for increased due diligence.”

It is all part of a broader inquiry by regulators into the relationships between end users and service providers, as mandated by the Dodd-Frank Act, for example.

“There is an understanding that some technologies need to be developed in-house because there is not a good vendor solution available,” said Neil McGovern, senior director of capital markets at SAP, a software provider. “However, we see more focus on ensuring that internal resources are focused on technology that can’t be bought off the shelf and that provides strategic differentiation.”

Regulators are interested in how management supports, and how auditors audit, the valuation assertion when companies use third-party pricing services to the determinate the fair value of investments which are not exchange-traded, which are typically classified as Level 2 or Level 3 assets, according to Dixon Hughes Goodman, a public accounting firm.

According to a Thomson Reuters survey of buy-side participants, nearly half (45.8%) of respondents wanted more transparency into the underlying information about the pricing of vendors’ offerings.

A clear evaluation process was cited as the top pricing vendor attribute by 31.3% of survey respondents, which includes operations staff, pricing managers, treasurers and chief risk officers.

The U.S. Securities and Exchange Commission (SEC) has signaled its intentions to address the use of evaluated pricing services on a systematic basis.

The SEC’s Division of Corporate Finance is including questions related to the use of pricing services in complying with the accounting and disclosure requirements in financial statements, management’s discussion and analysis disclosure, and management’s assessment of internal controls over financial reporting (a requirement of accounting rules stemming from the Sarbanes-Oxley Act).

The Public Company Accounting Oversight Board (PCAOB), which was created by Sarbanes-Oxley, has convened a pricing sources taskforce to inform its possible standard-setting or guidance around the use of pricing service information in estimating fair value.

The PCAOB’s report on the financial crisis noted deficiencies in auditing the fair value of complex financial instruments, as well as instances where auditors failed to understand the methods or assumptions used by third-party pricing services.

“Post-crisis changes to fair value measurement and disclosures have seen a shift in price discovery via the broker/client relationship to pricing vendor/client relationship,” said Fagas at Thomson Reuters. “This further highlights the demand for independent, third-party evaluated pricing.”

Thomson Reuters has increased its coverage on such hard-to-value assets as structured notes and jurisdictional-specific securities in emerging markets.

It also offers direct access to its staff of evaluators, many of whom have band market experience and backgrounds in trading, sales and research.

“This direct access allows for the challenge process to be highly effective and intelligent,” said Fagas.

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