The impact of regulatory reform on derivatives portfolio valuations
September 2014 | 10QUESTIONS | FINANCE & ACCOUNTING
FW speaks with James Dimech-DeBono, a partner at Grant Thornton, about the impact of regulatory reform on derivatives portfolio valuations.
FW: How would you characterise the current health of the global derivatives market? What trends and developments have you seen in recent years, in terms of volatility and increased scrutiny?
Dimech-DeBono: Prior to the global financial crisis, we observed a growing notional amount outstanding and gross market value of OTC derivatives – especially in the interest rate products – that reached a gross value peak in 2008. Since the crisis, we have observed a market whose gross market values are very volatile and whose behaviour is very out of character when compared to historic patterns. The investment management community, including Alternatives, is using more derivative products both for speculation and hedging. The amount of investor scrutiny and regulation has also increased since the crisis in both banking and investment management. Regulation was introduced in order to provide better protection to investors. There have been numerous well-documented cases of mis-selling derivative products across the globe. Other scandals, such as LIBOR-fixing, created more uncertainly in such volatile markets. Regulation is expected to curb such practices.
FW: What recent regulatory changes have come into play? What impact have new regulations had on trade execution processes and costs?
Dimech-DeBono: Better measures have been put in place to increase both transparency and investor protection since the global financial crisis. In 2013 and 2014, the European Union introduced the European Market Infrastructure Regulation (EMIR). This regulation places additional requirements on market participants to increase transparency around their practices. Through this increase in transparency, the European Union is attempting to ultimately reduce the level of risk inherent in the derivatives market. The US was ahead of the EU, as in 2010 the US market saw the introduction of the Dodd-Frank Act, which has objectives very similar to that of the EMIR. This, together with the advent of the Consumer Protection Act, increased disclosures to investors, and the SEC has become significantly important. All this regulation is having a significant impact on trade execution processes and costs. In a recent ISDA survey, 68 percent of respondents affirmed that costs related to hedging are increasing and 81 percent of them consider that the administrative burden related to hedging has also increased. The majority of the respondents agreed that market fragmentation is occurring along geographic lines as a result of regulation.
FW: More specifically, how have new regulations influenced derivatives valuations? Are you seeing a growing demand for independent pricing vendors?
Dimech-DeBono: Not surprisingly, the new regulation has had a significant impact on the valuation of derivatives. Investors now, more than ever, demand evidence that robust, consistent and transparent valuation approaches are being followed and that these approaches are aligned to industry standards. Banks typically have an Independent Price Verification (IPV) function that ensures a clear segregation of valuation duties from front office. In Europe, the European Banking Authority recently published its final draft Regulatory Technical Standards under the Capital Requirements Regulation, which set out the requirements on prudent valuation adjustments of fair valued positions. The purpose of such is to achieve an appropriate degree of certainty, having regard to the dynamic nature of trading book positions. The demand for pricing vendors to increase coverage has increased. However, more has to be done in this area as, although some vendors claim to have complete coverage across a particular asset class, when it comes to very bespoke and complex products, coverage at times remains rather poor.
FW: What advice can you offer to companies and investors on complying with global and local accounting, auditing and regulatory standards in relation to their derivatives portfolio?
Dimech-DeBono: This is something that should be considered a priority and action should be taken sooner rather than later. With the number of very significant changes in the pipeline around accounting standards for derivatives, which place quite onerous calculations and reporting requirements on companies, we suggest they seek advice as soon as possible. Taking accounting standards as an example, as of 1 January 2018 all companies with derivatives and reporting under IFRS will be required to adhere to IFRS 9 Financial Instruments as opposed to IAS 39, the current standard. Until then, UK companies currently have a choice to report under either of the standards. With the two standards having quite different requirements in accounting for, and disclosing within financial statements derivatives which standard you adhere to could have a major impact on the amount of work required. Hedge accounting rules are also changing and as a result we expect most companies to seek good advice on this matter.
FW: What kinds of risk exposures arise in connection with a derivatives portfolio?
Dimech-DeBono: Derivatives are a type of financial product which derive their value from their underlying asset movement. A stock option is a derivative where the underlying asset is stock. In order to understand risk exposure, it would be key to understand how derivatives are used by portfolio managers. Derivatives can provide a means of mitigating risk exposure within a portfolio through hedging. However, they can also increase the underlying risk exposure when they are used to speculate on the market and generate possibly additional return. With the two types of derivatives, Over-The-Counter (OTC) and Exchange-Traded (ET) derivatives, OTC derivatives are products that are privately exchanged and as such have the added counterparty credit risk exposure. Derivatives as such have a number of risks attached to them such as, price, interest rate, foreign exchange, and so on. Other important risk factors would be leverage, liquidity, basis risk, and so on. At a portfolio level, it is important to understand, measure and manage the interaction of such risks.
FW: To what extent does the valuation process help to manage or mitigate risks associated with a derivatives portfolio?
Dimech-DeBono: The valuation process itself does not directly manage or mitigate risk, as valuation produces an estimate or range of estimates of the worth of the derivative instruments. The valuation marks and uncertainty elements that emanate from the valuation process feed into the calculation of risk measures, help address, manage and inform the development of a mitigation strategy. Firstly, the simple aggregation of the valuation marks, as well as analysis of the process followed, will help to inform the value of the portfolio. Secondly, and more importantly, the valuation process itself needs to be evaluated or reviewed in order to help identify any inherent risks or pitfalls within the valuation process itself. The issues that these reviews can flag may include incomplete or absence of documentation, or inappropriate use valuation models for the derivatives in question. What is by far more important is to understand the extent of the exposure, such as the effect of leverage on the overall exposure. It is only through addressing some of these risks that a hedging strategy can be sensibly derived.
FW: What methods can be used to arrive at a transparent, accurate valuation of a derivatives portfolio?
Dimech-DeBono: Generally, using standard market-recognised valuation methodologies and models, if properly implemented, leads to a reasonable valuation estimate. This, in essence, also requires that the valuation analyst follows a transparent, robust, and consistent approach from one valuation period to the next. Investors and regulators alike should gain comfort that the valuation marks have been arrived at independently, consistently and ‘prudently’. At a high level, a robust valuation should be underpinned by: a strong governance process, including up-to-date and well-documented control policies and structures, including setting up the relevant committees; a validation of the underlying assumptions used; a review of the model code to gain comfort that the model’s implementation is correct; a review of the calibration process; a check of the model robustness, also called back-testing and stress-testing; a documented validation process that should encompass the previous steps; and a market follow-up on model development to ensure that the model, assumption and data used are still adequate for valuation purposes of the derivatives being valued.
FW: What penalties do firms face for missing reporting deadlines? What steps should be taken to ensure valuations are prepared and submitted on a timely basis?
Dimech-DeBono: The penalties for missing reporting deadline depend on the regulator in question. Generally, the penalties for first time offenders range from warnings from regulators through to fines. Regulators have wide-ranging powers and at the heart of their thinking is investor protection. Such measure penalise funds or companies. However, the most significant impact relates to bad publicity and loss of reputation. A recent study carried out by the University of Southern California, which looked at the impact to listed companies on missing SEC reporting deadlines, found that these companies experienced negative reactions immediately following the missed deadline, and continue to experience negative reactions for several months thereafter. Interestingly, the study found that the market actually penalised more the missing of quarterly reporting deadlines, as opposed to semi-annual or annual reporting deadlines – especially when accounting issues were cited for the missed deadline. Having a robust process in place remains the only alternative to meet valuation deadlines. This should be flexible enough to allow for contingencies.
FW: Do you see any further regulatory changes on the horizon? What are the implications for investment managers and institutional investors?
Dimech-DeBono: As a consequence of the global financial crisis, the financial markets have seen a number of regulatory changes. We strongly believe that we can expect further regulation over the next five to 10 years as the push for global regulatory reform gains further momentum. We are at a stage where the US and the EU are leading the way on regulatory reform but regulators elsewhere are also catching up. In addition, we expect regulatory reform to follow an iterative process as lessons are learnt and further changes are implemented. The introduction of new regulatory frameworks introduced over a relatively short period of time left investment managers scrambling for resources and eventually hit with high compliance costs. Such cost would ultimately be borne by investors. More integration and less duplication are necessary – for example, the development of a single global framework, which is on the G20’s agenda for banks worldwide, should be contemplated for the investment management industry.
FW: What final advice can you offer to firms on complying with regulations and maintaining an accurate valuation of their derivatives portfolio?
Dimech-DeBono: With the introduction of new regulation, the earlier this is addressed by the company the better. This usually entails setting up a working party to understand and look into the ramifications on the business. Once this is achieved, a resource plan and timetable are drawn up, highlighting any gaps and how these can be addressed. More often than not, external advisers are brought in to help manage the process as well as beef up the resources. When a framework and structure are in place, then the process should run smoothly. Any arising issues or new regulation should be dealt with and the process modified as necessary. Keeping abreast of market developments, of new information that becomes available, as well as newly-developed models, are all key to remaining ahead of the game.
Dr James Dimech-DeBono is a partner at Grant Thornton in London heading the Complex Asset Valuations & Advisory Services practice. He has more than 22 years of advisory experience. He provides clients with advice around the valuation of complex and illiquid assets. He can be contacted on +44 (0)20 7865 2595 or by email: firstname.lastname@example.org.
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