Industry Insight Series: The pivotal role of valuations in risk management

CloudMargin’s Industry Insight Series has been specifically created to shine a light on critical areas and themes within the financial services industry. Once a month, we will showcase expertise and viewpoints from industry figures who will highlight and discuss important areas in the market. The series has been designed to educate, inform and help you better understand complex issues within an ever-changing financial landscape.

Laura Kholodenko, IHS Markit

Laura Kholodenko is a Director and runs the Portfolio Valuations business at IHS Markit. Laura joined IHS Markit in 2008 and has helped to build and grow the derivative valuations business within various roles including Head of Portfolio Valuations Operations in North America and Credit Derivative Product Specialist. Prior to joining to IHS Markit, Laura was a securitization analyst at Deloitte. Laura holds a BSc in Finance from Rutgers University.


The pivotal role of valuations in risk management

The way things were…

As financial firms know too well, the industry at large has undergone a major transformation since the 2008 Global Financial Crisis. Most global economic crises are followed by a series of regulations designed to protect investors and counterparties, as well as prevent future recurrence. The most recent crisis has proved no different. BBA’s ‘BBA Briefing’ paper estimates that the European banking industry alone has had ‘over 80 pieces of legislation passed to make the financial system more stable and secure’.

Rewinding the clock further, the stock market crash of 1929 and the resulting Great Depression paved the way for many important securities and fund regulations, most namely the Investment Company Act of 1940. Years later, the emphasis on oversight, disclosure, and fair value highlighted the importance of independent and accurate valuations in a fund’s financials. Funds started to move away from front-office driven valuations and reliance on a single source to the use of multiple independent valuation sources and inputs.

The 2008 Global Financial Crisis highlighted the importance of counterparty risk and placed even greater emphasis on independent and accurate valuations. Many funds that previously relied on counterparties as a valuation source started to use independent valuations and initiated a daily process to reconcile trade terms and valuations.

Market conditions as a result of the crisis also highlighted the importance of accurate input assumptions and methodologies. This was particularly made evident in credit derivative models that used standard recovery rates as assumptions for calculation of expected loss. Given the high number of defaults and lower than expected actual recovery amounts, models used at the time could not calibrate appropriate results. This caused quite a bit discussion in the industry but more importantly highlighted that having a way to validate and check for valuation accuracy was a key focus.

Today, valuations and collateral processes align for sound risk management…

Now in this post-crisis era, the industry has been mandated to collateralize derivatives and other complex financial instruments. This means that trades governed by an ISDA Credit Support Annex (CSA) require collateral to be exchanged in order mitigate the credit risk of a counterparty. This also gives rise to a suite of new valuation challenges, such as the use of the Overnight Index Swap rate (OIS) vs. London Interbank Offered Rate (LIBOR) discounting – a key input used to calculate the present value of nearly all types of derivative transactions.

Before the crisis, LIBOR rates were seen as, essentially, risk-free rates. However, this started to change post-crisis as LIBOR rates increased and the spread between overnight rates (rates at which collateral is funded) and LIBOR increased. Many firms experienced challenges in sourcing appropriate data to implement the new discounting methodology, and the number of valuation differences compared to counterparties grew significantly as vendors and counterparties transitioned to the new methodology. Therefore, regular reconciliation of valuations became important to identify and explain exceptions.

The rise of clearing as the result of Dodd-Frank and EMIR rules also creates a new set of pricing challenges as most firms continue to rely on bilateral over-the-counter (OTC) prices for the purpose of valuations and reporting for cleared positions. Moreover, the same position cleared at different central counterparties (CCPs) may result in different settlement prices. This has highlighted the need for firms to more closely align valuations and collateral management processes to account for, and reconcile, such differences.

As the requirements for risk and sensitivity reporting grows, funds are looking to align the analytics and underlying inputs used for valuations with those used in risk management. The trend toward intraday profit and loss (PnL) and risk monitoring also creates a need to implement consistent approaches and methodologies.

This is just the beginning…

The importance of independent, accurate and consistent valuations will continue to play an important role for the new mandatory variation and initial margin rules. As the number of CSAs and resulting margin calls a firm will need to manage grows, valuations will play a key role in helping firms automate and optimize their collateral management process. Being able to calculate expected variation margin calls as well as initial margin will help firms manage operational, liquidity and legal risk. We will also see a trend toward using cheapest-to-deliver discounting under multi-currency CSAs, which again highlights the key link between valuations and collateral management.

The future of valuations will also mean more disclosures and enhanced reporting as regulations develop. The U.S Securities and Exchange Commission (SEC) is doing this with the new modernization rules calling for greater transparency into fund accounting and portfolio risk analysis and reporting. As regulatory requirements continue to grow, using consistent sources of inputs and valuations will be critical for compliance, risk management and operational efficiency. 

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