Evaluating OTC Derivatives Exposure

Market volatility and shocks to the financial system have prompted regulators, as well as institutional investors, to demand increasing independence and transparency for over-the-counter (OTC) derivative valuations. In July, the U.S. Senate approved legislation calling for comprehensive regulation of the OTC derivatives marketplace. Under the bill, those involved in derivative and swap transactions, as well as large traders in OTC contracts, are subject to reporting and record keeping requirements amongst other responsibilities and regulations.

Even before the bill made its way to the President to be signed, many firms had started to review OTC derivative valuation and collateral management with an eye toward adopting best practices and standardization across the industry.

Valuations

The buy-side’s approaches to valuations currently include counterparties, independent vendors and internal valuation groups. Although counterparty marks remain a popular and an inexpensive option, they have a number of drawbacks, including potential conflicts of interest, lack of transparency, possible errors and infrequent occurrence. For these reasons, auditors, regulators and investors are all moving away from counterparty valuations. Still, about 19% of asset managers or institutional investors rely on their counterparties for OTC derivative valuations, according to a May 2010 online survey by Absolute Return Magazine.

Outsourcing the valuation of products to independent vendors is an alternative course of action. There are a number of benefits in doing so, including cost efficiency, fast implementation, scalability and flexibility. On the negative side, valuation expertise and thorough understanding is not developed internally.

Another alternative that buy-side firms may consider is to build a valuation group, such as at an investment bank. This has the advantage of complete transparency, while also promoting a better understanding of the investments. However, there are significant infrastructure and market data costs, as well as a need to attract and retain talent.

In addition to merely valuing the positions, firms emphasize other aspects or attributes of the valuations to frame the risk involved. For instance, accrual calculations, sensitivity to the underlying instruments and key assumptions are all relative to qualify the valuation. In turn, this information enables firms to carry out performance attribution, measure and manage counterparty risk, estimate and prepare for future collateral calls, and generally improve risk management.

Sound controls would include the preparation of valuation transparency reports for all derivative valuations. Reports include a deal description, market data, primary valuation issue, model selection and calibration strategy, unobservable parameters, as well as primary and secondary valuation sensitivities. Best practice suggests proper documentation of a pricing policy involving transparent independent valuations.

Collateral Management

The use of collateral to mitigate counterparty credit risk is another trend that has been on the rise. That’s because collateralization tends to:

• provide both parties to a transaction with protection against default
• reduce regulatory capital requirements
• permit more business under existing credit facilities
• provide access to greater revenue-generating opportunities with riskier, more volatile transactions
• ensure that industry-standard documentation exists

Historically, the broker dealers would call collateral away from the buy-side with far fewer movements in the other direction. We expect this practice, also known as collateral arbitrage, to continue to decline because end users are increasingly concerned about broker-dealer bankruptcy risk.

Also of importance is the segregation of any collateral that has been pledged to the broker-dealers. As a result of the Lehman Brothers bankruptcy, end users that had pledged independent amounts — a type of initial margin levied on individual OTC derivative transactions that often resulted in over-collateralization — were seen as general creditors and only managed to recoup cents on the dollar. Since then, alternative methods of storing collateral have emerged; segregated accounts at the broker or the use of third-party custodians are in the most demand.

Toward Higher Standards

Stringent regulation in the financial industry will affect both valuations and collateral management for OTC derivatives. Valuations should become much more transparent as trades are cleared centrally and/or reported in industry warehouse utilities. For trades that are centrally cleared, the collateral — or margin process — becomes highly standardized to resemble that of the listed derivative market where counterparty risk is all but negated. However, not all instruments will be initial candidates for central clearing and until then, it is up to the buy-side and end users to employ higher standards of care for OTC derivatives. Through Northern Trust’s derivative services, including independent valuations and collateral management, we are able to support our clients with these complex instruments regardless if they remain OTC or become centrally cleared.

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