Exotic Product Valuations Get Regulatory Scrutiny

Nomura fine provides good lessons for fund managers

CHRISTIAN SZYLAR, RISK MANAGEMENT SOLUTIONS, KINETIC PARTNERS

On 16 November 2009 Nomura International was fined £1.75 million for breaches of Financial Service Authority principles. The specific principles were Principle 2 – failing to conduct its business with due skill, care and diligence, and Principle 3 – failing to take reasonable care to organise and control its affairs responsibly and effectively. The area of valuations of exotic products is now at the fore of the regulator’s attention. The global financial crisis exposed significant weaknesses in the risk management practices of many funds and banks. Investors and regulatorsare now demanding that the investment banks and the asset management industry implement far stronger risk management processes, including OTC valuation. In respect of the asset management industry, their concerns are illustrated by the EU’s inclusion of requirements for funds to provide far better risk management reporting in the UCITS IV Directive and the draft Alternative Investment Fund Management (AIFM) Directive.

The Nomura case
Nomura discovered incidences of mismarking and mounted its own internal investigation, appointing outside consultants to review this area; the original mismarking was an overvaluation of £10.8 million. The FSA view on such matters is clear. “The FSA considers that firms should take care to price financial instruments correctly. Particular care must be taken to price derivatives and other complex products accurately and ensure that individuals with a potential incentive to mis–mark are properly controlled. The FSA considers the proper functioning of an independent price verification process to be a vital element in this task. If a firm does not have the resources or institutional experience adequately to supervise an activity it should not undertake it.” Nomura had set up a worldwide equity derivatives business with centres in New York, Hong Kong and London. Trading was done for the firm’s own account and on behalf of clients, and Nomura also issued structured equity products to high net worth individuals via private banks. Traders were required to mark their books for certain variables including implied volatility, correlation and dividends. These parameters need to be monitored effectively, not only by the front office but also on an independent basis by product control as part of the independent price verification (“IPV”) process. This process is especially important in turbulent markets.

A key process used by product control to ensure the accuracy of implied volatility, correlation and dividend marking by traders, is the IPV process whereby market prices or model inputs for derivatives are regularly and independently verified for accuracy. The objective of the IPV process is to reveal any error or bias in pricing, and it should result in the elimination of inaccurate marks. The three key points that were identified surrounding product control were:

1. Inappropriate communications and disclosures between product control and the front office regarding the IPV process.

2. Inappropriate and limited stock selection for testing by product control, in respect of both volatility marks and dividend marks.

3. Failings around the testing methodology used by product control and the analysis of test results.

Also highlighted in the notice were the following points:

• Product control gave the front office advance notice of the stocks that were to be included in the month end IPV process as a matter of course. This fundamentally undermined the verification process and left the system open to abuse. This rendered the IPV process ineffective to deter or detect mis-marking.
• Only a small selection of stocks was tested, the majority being untested for a long period of time.
• Price testing did not focus on illiquid underlying stocks despite the fact that illiquid stocks carry more risk of mis-marking.
• Product control did not use the P/L attribution reports to assist in selecting stocks for price testing, i.e. choosing positions that were registering large P/L movements.
• Product control failed to carry out any ‘sense check’ and should have spotted that for the same underlying option, long positions had been marked with very high volatilities and short positions had been marked with very low volatilities.

Lead up and regulator comments
In August 2008, the FSA issued a letter for CEOs and those individuals responsible for the appointment and oversight of valuation controls in large and/or complex principal trading operations within banks and investment firms. Inits letter, the FSA reiterates the importance of having a robust valuation control process. The letter is also intended to inform the industry about the regulator’s prudent valuation principles and describes the major steps to apply these principles in the trading businesses.

In reviewing what has been done over the last few years it is clear that the valuation processes in place were less than satisfactory. Despite the existence of prudent valuation principles and pricing policies, the recent market turmoil has demonstrated that there were still gaps. The valuation of financial instruments is one of the most important steps (if not the most critical), as pricing will determine the way to measure the inherent risk as well as the liquidity risk. Therefore the validity of models behind pricing, combined with strong pricing policies, constitutes the foundation of the architecture.

Application to UCITS
UCITS are now permitted to use derivatives as part of their general investment policies, as well as for hedging. A consequence of this is that UCITS must establish an extensive system of risk management in order to ensure that the risks involved in using derivatives are properly managed, measured and monitored on an ongoing basis. This involves:

• designing, implementing and documenting a comprehensive risk management process in order to meet the key requirement of investor protection;
• extending disclosure duties;
• defining a rule of conduct to ensure that companies act in the best interests of the UCITS and their investors and the integrity of the market.

Under the UCITS regime the OTC valuation process has to be detailed and communicated to the regulators. OTC financial derivative instruments must be accurately and independently valued. It should also be possible to verify the valuations on a daily basis. Each UCITS must be able to determine with reasonable precision the fair value of OTC financial derivative instruments throughout their lives. The valuation must be based on a current market value. If such a market value is not available, then the valuation should be based on a valuation model that uses a recognised and accepted methodology. The UCITS may use third party valuation systems or market data but must verify their adequacy. In theory the principles are reasonable but in practice this has led to several problems mainly linked with the transparency around models used to value these instruments; the scientific validity of these models; their ability to consider all the risk aspects inherent to the specific product; and, mainly, the competencies and skills of those supposed to review and question the models.

CESR Guidelines, March 2007
The CESR guidelines cover several key points on valuation. Among them:

• The “process for accurate and independent assessment of the value of the OTC derivatives” requires: “a process which enables the UCITS throughout the life of the derivative to value the investment concerned with reasonable accuracy at its fair value on a reliable basis reflecting an up-to-date market value”
• “a risk analysis realised by a department independent from commercial or operational units and from the counterparty or, if these conditions cannot be fulfilled, by an independent third-party… in the latter case, the UCITS remains responsible for the correct valuation of the OTC derivatives….”

The AIFM Directive
On 29 April 2009, the European Commission proposed legislation designed to impose the first European-wide regulation of alternative investment capital pools, including hedge funds, in an effort to reduce systemic risk and harmonise regulation in the European Union. The proposed AIFM Directive details rules regarding independent valuation and disclosures to investors and reporting to regulators. As we can see, regulators want funds to address specific issues, such as OTC valuation, liquidity, leverage and counterparty risk, all areas which were exposed as inadequately monitored during the recent global financial crisis. Pricing (the time the OTC derivative transaction takes place) and valuation (the ongoing value of the OTC derivative) are creating sensitive problems. Because of their specifications, OTC derivatives require new types of market data as well as mathematical models and, at the same time, bring new challenges in sourcing, storing, managing, controlling and distributing data. It is therefore not surprising that the desire to outsource this process has become popular. Using a third party valuation system or outsourcing the valuation process to a third party administrator may bring a number of benefits, as long as certain points are kept in view: systems need to have access to large amounts of historical time series data and proposed valuation models should be reliable and communicated (some service providers do not explain the models that underpin their price verification). If the model is unknown it will be impossible for those ultimately responsible for the valuation to stress-test it and question/modify the assumptions or challenge staffing to verify whether adequately skilled and experienced people are servicing the valuation model.

Conclusion
Increased regulation of OTC valuations raise some practical questions for both investment banks and asset managers, particularly in the case of exotic products. OTC products provide yield enhancement and greater flexibility in terms of risk hedging but, at the same time, organisations must reinforce their capability to understand how these complex products work and the pricing models behind the engineering. Kinetic Partners has launched Risk and Valuation Services (RVS) to deliver risk services for funds in one seamless process, to help both traditional and alternative managers implement robust and effective risk management systems.

Christian Szylar heads Kinetic Partners’ Risk and Valuation Services practice. Previously, he was managing director of RBS Portfolio Risk Services. He holds a PhD in management science and has furthered his studies with the MIT Sloan School of Management.