Valuation of derivatives and complex securities
April 2015 | 10QUESTIONS | BANKING & FINANCE
financierworldwide.com
FW speaks with Dr James Dimech-DeBono, a senior managing director in FTI Consulting’s Economic and Financial Consulting segment in EMEA, about the valuation of derivatives and complex securities.
FW: Could you provide an overview of recent developments affecting complex securities and derivatives? How would you describe trading volumes, swap markets, and the recent growth of the CLO space?
Dimech-DeBono: Generally, there are a number of trends that affect the financial services industry and complex securities and derivatives. These include, firstly, the whole financial system is changing and the roles within the system are shifting. For example, as regulation takes effect banks are changing their offering portfolios accordingly, and exiting some areas where they have traditionally been strong players. As a result, asset managers have been filling the void left by the banks. Secondly, there has been a marked increase in alternatives and thus more investment in illiquid assets. Given these two points, an element of heavy-handed regulation is expected to address various issues including systemic risk. The third major trend has been the move towards more standardised clearing for derivatives. Over the last year or so, we have seen an increase in derivatives trading volumes. However, this has been a bit of a mixed story in some asset classes and market segments when compared to a year earlier. With respect to the Interest Rate Swaps (IRS), the European Union is expected to make IRS clearing mandatory during the course of the next year, while LCH Clearnet is now offering inflation swap clearing. In the CLO markets we observed growth during 2014. In fact, according to S&P Capital IQ, the CLO market is at a juncture. 2015 could be a great year for CLO issuers and investors, but it could also be a very troubling year for both. CLO managers issued a record $124.1bn in 2014. Despite the high issuance observed during the first quarter of 2015, concerns remain on the broader loan market and the adequacy of the risk retention solutions currently available. Furthermore, equity investors may face difficulties if spreads tighten and arbitrage opportunities disappear.
FW: In what ways is valuation modelling and analytics evolving to meet market demands?
Dimech-DeBono: The main impetus behind the evolution of valuation modelling and analytics comes from the increased regulation that affects financial institutions, and by those we mean banks, investment managers and insurers. The demand to improve in this area is, in a way, defined by regulation rather than this being a question of aspiring to be ‘best in class’ versus your peers. Valuation is continually evolving as new products come into play, further research into new modelling techniques is published and better information becomes available. Once any of these happens and models are implemented to the extent that they gain industry-wide recognition, they become integrated into the analytics platform directly by the institution or third party that is responsible for the systems in place.
“Valuation is continually evolving as new products come into play, further research into new modelling techniques is published and better information becomes available.”
FW: What advice would you give to firms that are facing liquidity issues on securities within their portfolios as to how these aspects feed into valuations?
Dimech-DeBono: Liquidity issues certainly have an impact on valuation, and the price a firm can command when disposing of illiquid or less liquid securities. We have observed such issues even when dealing with thinly-traded stocks and the fact that the market is unable to absorb the sales of a large block of shares. Accordingly, this is a situation where a market exists. However, the situation becomes more acute in situations where a market is not necessarily available, such as in those situations where a portfolio includes, for example, OTC derivatives, securities in private equity holdings or distressed debt. In all these situations, the lack of liquidity has to be factored into the valuation. Calibrating for such an issue is by no means an easy task. Empirical methods may be used as long as there is data to work from; however, more often than not an element of judgement comes into play. Liquidity is not just a valuation problem and sound measures should be taken in order to address the issue in a broader fashion. The Bank for International Settlements (BIS) provided guidance on the liquidity problem back in 2008 and the main principles of this framework are the importance on establishing a liquidity risk tolerance, the maintenance of an adequate level of liquidity, the necessity of allocating liquidity costs, benefits and risks to all business activities, the identification and measurement of full range of liquidity risk, the ability to design and use of stress tests, a robust and operational contingency funding plan and the management of intraday liquidity risk and collateral. It seems fairly obvious to note that such a framework is applicable across the financial services industry.
FW: How would you evaluate the initial policy proposals which emerged from the Basel Committee’s review of trading book capital requirements? How are the Committee’s findings likely to impact on the valuation of complex derivatives and securities?
Dimech-DeBono: The policy proposal is in reference to the definition of capital requirements stemming from market risk. The proposal sets out a limited set of revisions to the Basel Committee’s proposed market risk framework, which was published in October 2013. That second consultative proposal put forward a revised market risk framework to address weaknesses in risk measurement under the current framework’s internal models-based and standardised approaches. This appears to be similar to credit risk approach previously taken. The policy is being refined by taking into account consultation feedback and results from two QISs. The first main point under consultation is the treatment of internal risk transfer, or hedging, of equity and rates risk between the trading and banking book. While addressing the issue of avoiding capital arbitrage, this acknowledges that hedging activities may be better placed with traders as this leads to efficient trade execution and better management of counterparty risk. The second main point concerns the need for risk sensitivities to be more easily incorporated into the standardised approach. The third main point is the incorporation of liquidity horizons into internal models. The additional capital requirements will have an impact on valuation in the form of a ‘CVA-type’ measure – in the same way as capital requirements for counterparty credit risk – as market risk is eventually priced in.
FW: In terms of portfolio valuations, to what extent can plain vanilla instruments bring complexity to the process?
Dimech-DeBono: Let us first start by defining a plain vanilla instrument. For the purpose of answering this question, let’s use a portfolio of loans made up of corporate loans, SME loans and residential mortgages. Each of these securities should be straightforward as each pay an interest and make a contribution toward the capital repayment. Assuming that the data is readily available and complete, which in many instances may not be the case, we start by extracting the information and categorising the loan portfolio into relevant buckets, for example by market segment, industry type geography, performing and non-performing, and so on. Next we must look into the methodology question and to what level of detail the model goes into. More often than not the latter question is a function of the information available for calibration purposes. If we were to keep this simple, the model would calculate the NPV of expected cashflows based on assumed PDs, LGDs and EADs. If we are to add more ‘complexity’ we can take into account, for example, prepayments and correlation between PD and LGD. Other aspects to be considered in such an exercise are stress testing and whether there is any benefit in the model being stochastic or not. In this particular example, we can see how what many consider to be a plain vanilla valuation may not be so plain after all, as complexity can always creep in.
“Counterparty credit risk is a topic that has gained significant recognition since the global financial crisis and has been at the top of many front office agendas.”
FW: How significant are credit, debit and funding valuation adjustments as far as they apply to complex assets? What are the particular challenges posed by wrong way risk and exposure? To what extent can CVA, DVA or KVA assist in this regard?
Dimech-DeBono: Counterparty credit risk is a topic that has gained significant recognition since the global financial crisis and has been at the top of many front office agendas. The overall perception of counterparty credit risk has changed to such an extent that is presenting new technical challenges in banks across regulatory, accounting, risk management and front office functions. IFRS 13, which deals with fair value measurement, places significant importance on the complex component of fair value CVA and DVA. This in itself requires banks to develop a more sophisticated approach as now auditors have specific standards that have to be adhered to. IFRS 13 necessitates a move from historically- based to risk neutral parameters when quantifying CVA. Working with risk neutral parameters has implications when calculating default probabilities, and for institutions this means that accounting CVA numbers are more volatile. Some banks question the use of DVA as this implies that they profit as a result of their decline in credit quality and lead to hedges creating wrong way and systemic risk. Some view DVA as a component that can be monetised while others see DVA as more of a funding benefit. The latter implies that the links between DVA and funding must be looked into.
FW: How important are external independent valuation services to the investment management industry? Is there a growing demand for practical guidance around transparent, defensible valuations?
Dimech-DeBono: Regulation, such as AIFMD, seeks to address the question as to how independent internally-generated valuations were and the fact that statutory audits were not necessarily addressing the issue of valuation in the context of the investment management industry. This has added momentum to firms who provide independent portfolio valuation services to the industry, especially alternatives. The focus still remains on the more illiquid asset classes such as private equity, infrastructure, structured deals and distressed situations. Besides regulation, over the last few years various industry bodies, such as IPEV, AIMA and HFSB, among others, have also issued valuation guidance as an attempt for the industry to self-regulate and define best practice. Added to these industry bodies, the accounting standard setters also produced Fair Value Standards. Others, such as the International Valuations Standards Committee (IVSC), have added their guidance. There is ample guidance to follow and there are obvious benefits in having an independent third party look into how this is actually implemented and whether ‘best practice’ is being adhered to.
FW: Could you explain some of the operational implications for firms of complying with AIFMD valuation expectations? Have asset managers fully embraced and engaged with AIFMD requirements?
Dimech-DeBono: From an operational perspective, the main challenges would stem from having the right resources in place. These include people, systems and controls. Having a proper governance structure is at the heart of AIMFD, including separation of duties to achieve independent valuation marks. In other words, this entails having a distinct valuation back-office function, similar to the Independent Price Verification function in investment banks. The responsibility for producing valuations for the monthly NAVs lies with this function that would then report to the valuations committee for final approval by the board. Having segregation of duties can be difficult, especially for small asset managers or in very illiquid, specialist asset classes. As a consequence, we have seen an increase in enquiries for independent valuation services, especially when related to illiquid or hard-to-value assets. Asset managers are still grappling with the requirements of AIFMD, and the fact that in the UK the Financial Conduct Authority is investigating 67 fund managers for alleged offences that fall within the scope of the AIFMD is testament to this.
“For the less liquid and complex assets, having reliable and consistent data-feeds that allow for the derivation of model parameters and an analytics platform that enables the valuation to be performed would become a must.”
FW: What methods and strategies can be implemented to address the increasing day-to-day demands of asset managers and their valuation and pricing requirements?
Dimech-DeBono: At a very basic level any valuation or asset pricing should be based on a consistent and reliable source. This may be easily achieved for level one assets, however when dealing with level twos or threes, the problem becomes more complex. For the less liquid and complex assets, having reliable and consistent data-feeds that allow for the derivation of model parameters and an analytics platform that enables the valuation to be performed would become a must. When marking-to-model, particular attention should be paid to ensuing that valuations are consistently performed and adhere to the proper policies and procedure that are in place within the organisation. With some asset classes, the obvious question around the frequency of the valuation needs to be addressed. For example, when dealing with private equity or infrastructure deals, unless something dramatic within the investment or the market has occurred, there may be limited benefit to updating the valuation of the underlying investment on a daily or weekly basis. In other words, a ‘common sense’ approach should prevail.
FW: What trends do you expect to unfold in the valuation of complex derivatives and securities over the coming months? Will this issue only become more important in today’s heightened regulatory environment?
Dimech-DeBono: There is a renewed focus on asset managers due to AIFMD. More attention is being paid to alternative investments due to their nature and the valuation issues they bring. We expect to see more sophisticated and quantitative techniques employed to measure performance and risk. While such techniques are typically used for portfolios of derivatives, similar techniques would be employed to private equity or infrastructure portfolios. These techniques may involve a NAV-time series-based modelling approach, cash flow model-based VaR calculation, and stress testing. Stress testing within the private equity space would look at, for example, lower IRRs or multiples than have historically been achieved by funds , longer lifetimes of funds, accelerated draw-downs, delayed repayments, higher volatility of cash flows and a higher degree of dependency between funds. Stress testing is particularly important as the IMF is now seeking to stress test asset managers, particularly as the investment management industry has filled the void left by banks which have withdrawn from markets because of certain capital rules. The IMF recognises that the asset management industry is not necessarily set up to fully address the risks at an institutional or systemic level.
Dr James Dimech-DeBono is a senior managing director in FTI Consulting’s Economic and Financial Consulting segment in EMEA. Dr Dimech-DeBono’s focus is on the financial services sector with a particular emphasis on risk management and the valuation of complex assets. He has more than 25 years of advisory experience, working with clients ranging from banking institutions to investment managers and regulators in the areas of valuation, risk management and hedging. Dr Dimech-DeBono has led a number of European Central Bank AQRs across the Eurozone, providing technical and quantitative expertise to various regulators. He can be contacted on +44 (0)20 3727 1731 or by email: james.dimech-debono@fticonsulting.com.
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