With global financial regulation demanding more transparency in OTC derivatives trading, the cost of valuations could fall.
In pushing over-the-counter derivatives trading onto exchanges, financial regulators might be helping treasurers in at least one regard: by pushing down the cost of derivative valuations services. That’s because in demanding transparency, suddenly all derivatives-related data becomes more easily accessed – via trade repositories, broker dealers and exchanges – and thus more of a commodity.
But this doesn’t mean valuation services won’t be needed. Indeed, according to a report from TABB Group, a financial research and strategic advisory firm, spending on OTC valuations is expected to increase by 18.1 percent to $294 million by 2013.
Nonetheless, it will be a more competitive market, said Andy Nybo, a principal & head of derivatives research at TABB Group. In the new world of central clearing, Mr. Nybo said, the global regulatory environment is more about transparency and providing more accurate information so that regulators can better monitor global systemic risk. The benefit of this is that there will be a “huge amount of new data on what had formerly been in an opaque [OTC derivative] marketplace,” which now will be consolidated – and more easily accessed by new valuation entrants or companies themselves – in various clearing entities and trade repositories.
The result is that with large amounts of data available and more transparency, “the data and pricing inevitably becomes a commodity-like product, which means you can no longer charge a premium or get a higher price” for the data,” Mr. Nybo said. In the context of fair-value accounting, also, the quoted market price for standard contracts becomes a straight-forward Level One valuation. Still, while commoditization will impact the pricing ability of the valuation services, it also will lower costs for them as well, he noted. In any case, it will ultimately help treasurers because pricing and revaluing their derivatives portfolio will cost much less. Jiro Okochi, CEO and co-founder of derivative valuation, management and hedge accounting services provider Reval, agreed that changes and, more specifically, standardization, will come with regulation. He said moving OTC derivatives trading to exchanges could create standardized instruments that trade in a liquid and transparent way. Because of this, he said, new benchmarks could be created.
For example, Mr. Okochi said, a company could use five-year strips of eurodollar futures or five-year government bond indices to price certain interest-rate swaps. “But if the market started to trade standardized five-year swaps, then in theory you would have no need to use futures or bonds to hedge the position but would just buy and sell the actual underlying instrument,” Mr. Okochi said. But it will be a challenge for the exchanges to create standardized instruments that could be used in this way, he added.
With these new benchmarks now trading on exchanges, systems vendors would have to incorporate the new benchmarks into their models, which Mr. Okochi said happens from time to time anyway. “I don’t think this necessarily means that pricing services go away,” he said. “My guess is that there will still be customized swaps that do not match the benchmarks.” TABB’s Mr. Nybo agreed saying there will always be a market “to more accurately price exotic securities where there may not be a wealth of data or a wealth of pricing information.”
“At the end of the day, valuation service providers will have to compete on service and on the ability to integrate the data sets with analytics and risk models,” Mr. Nybo said. And they will nonetheless be critical to portfolio valuations as investors will continue to want access to independent and unbiased sources of information. Still, there is no question that Dodd-Frank impacts their business, and not necessarily in a welcome way.