Vendors join race to provide evaluated pricing

Providers of evaluated pricing services have a thing about garbage. By that they mean pricing-related garbage, which in the fixed-income markets can be plentiful. Illiquidity is to blame. For example, only about one-sixth of US and European corporate bonds trade on a daily basis. Consequently, for a lot of corporate bonds, it is questionable whether reported prices fairly reflect the economic value of the debt.

In securitisation markets, asset pricing tends to be even more opaque. For example, in the European structured finance market, it is estimated that less than 5% of securities trade on a day-to-day basis.

In this and other markets that are relatively illiquid, a pure reliance on trade data and broker quotes for valuations can look suspect. In extreme cases, involving very rarely traded securities, stale prices can persist for months at a time.

Even with more liquid securities, a trader who has seen no activity in a bond, and perhaps has no interest in it, may simply churn out the same reference price each day.

An evaluated price, which takes all publicly available information to arrive at an independently formed price opinion, provides an alternative avenue to valuation. Such prices will look to incorporate broker quotes and market data, but are not dependent on them. In addition, evaluated pricing is analytically driven.

"Evaluated pricing is a combination between theoretical fair market value and actual dealer input," says Karl Mackelburg, at Reuters DataScope, in New York.

Reuters DataScope is among a handful of large providers of evaluated pricing services. The other big providers are FT Interactive Data, and Standard & Poor’s Securities Evaluations.

Notes Ian Blance, vice-president of capital markets Europe, at FT Interactive Data: "Trading is only part of the picture. The fact that a company is traded doesn’t mean it is the true valuation. If we get a price from a bank that conflicts with the rest of the information we are seeing, we can exercise a level of judgement."

Pricing models and a hierarchy of market information are used to arrive at that judgement. Says Peter Jones, director of European securities evaluations at Standard & Poor’s Securities Evaluations: "The types of market information pricing models rely on as a basis for valuation of a security include actual trade data; actual trade data on comparable bonds; primary market data on comparable bonds; spread levels of ‘active’ bonds and input from the sell side and/or buy side. Ultimately the evaluation is our opinion of the value of the security."

For some assets, if an evaluator decides that this type of market approach does not fully reflect the true market value of the security, a future cashflow approach or liquidation approach is adopted. Such approaches involve the use of fundamental information concerning the bond issue or credit, notes Jones, including financial statements, trustee notices and obligor communications with bondholders.

Providers of evaluated pricing argue that their approach is a more consistent and transparent way to value illiquid instruments, compared with a pure reliance on market pricing data. However, take-up of evaluated pricing varies markedly.

Broker quotes, along with actual trade data, often form the main basis for valuations of securities, including the more illiquid types of holdings.

That is particularly the case in Europe, where evaluated pricing services have established themselves only relatively recently. That is in contrast to North America, where evaluated pricing can be traced back over several decades, reflecting the long history of markets such as US municipal and junk bonds.

Today, fixed income evaluated pricing plays a central role in the reporting of the NAVs of US exchange-listed mutual funds.

However, in the European market, operational guidelines often stipulate that contributed pricing – in other words, a reliance on broker quotes and actual trade data – should be used before an evaluated price.

Perceptions appear partly to explain why evaluated pricing often plays second fiddle to contributed pricing. In crude terms, evaluated pricing can be viewed as ‘boffin’ pricing. In addition there is a cost attached to obtaining evaluated prices, over basic market-sourced data.

Evaluated pricing is also of greater or lesser relevance depending on the type of user. For front offices, it is market realities that matter. An executable trading price may or may not reflect fair value. However, for the trader it is the only price that counts.

In contrast, middle and back office and compliance staff are interested in ensuring that valuations reflect true economic value. In those areas, evaluated pricing providers are pushing their businesses harder than ever – both in Europe and elsewhere.

Pricing transparency is continuing to move up the agenda, as less liquid asset types get incorporated more and more into investment strategies. And it is no coincidence that a requirement for independent, externally sourced valuations is finding its way increasingly into internal risk management guidelines.

Meanwhile, regulatory concern over the valuation of illiquid securities is widespread, driven in large part by the development of OTC derivative instruments. In addition, new regimes, such as International Accounting Standard 39, which lays out principles for fair value hedges, are helping to reform valuation practices.

Reflecting these factors, independent valuations services are today a honey pot. New companies are planning to enter the market, including Bloomberg. The company has been hiring aggressively in North America and Europe, and is due to launch an evaluated pricing service in the fourth quarter of this year.

Moreover, evaluated pricing providers are not the only valuation services that are seeking a slice of the action. Other types of firm that are offering these services include Markit, which is developing a valuations business off the back of its consolidated pricing data business. The firm, which is the credit derivative market’s main provider of consolidated prices, and also a provider of cash credit data, announced the full, public launch of a portfolio valuations service in April.

Consolidated pricing is the mathematical average of a collection of broker-dealer prices, which are checked for quality. Such prices are obtained from highly liquid, exchange traded markets, as well as from over-the-counter markets. Bloomberg, Reuters, and ICMA (previously ISMA) are other examples of consolidated price providers.

Evaluated pricing providers make use of consolidated price sources, but with caveats.

Says Blance at FT Interactive Data: "Contributed pricing is useful, but it depends on the level of contribution. The less activity there is in a particular instrument, the more difficult it can be to get a good contributor price."

The transparency of contributed pricing can be another issue for evaluated pricing providers. The sourcing and processing of the underlying data contributing to a consolidated price can in many instances be difficult to query.

Examples of other types of firm that offer independent valuation services include Independent Valuation and Risk Services, a company owned by trading systems and risk management software vendor Lombard Risk. Lombard has its roots in modelling complex structures, and until recently ran a credit derivatives pricing service, called ValuSpread – now owned by Fitch Ratings.

Lombard continues to have access to ValuSpread. Independent Valuation and Risk Services provides independent valuations across vanilla and complex derivatives.

For all these types of services, forging of new alliances is proving to be key, as the range of asset types that are finding their way into portfolios grows.

Recent examples include Markit’s acquisition of North American structured finance modelling firm, Chasen, as well as Independent Valuation and Risk Service’s partnership with structured credit pricing software vendor, CDO2 Solutions.

Evaluated pricing services are also extending their net through new alliances. "Clients don’t want to take three or four solutions through three or four channels. That is a driver behind forging new alliances and working to supply multiple asset content via one channel," says Jones at Standard & Poor’s Securities Evaluations.

Demand for credit derivative and other OTC derivative valuations have been one factor behind recent alliances. For example, Standard & Poor’s announced an alliance with financial engineering firm, Complex Security Valuations, in April of this year.

The alliance covers instruments such as total return swaps, interest rate swaps and credit default swaps.

Meanwhile, FT Interactive Data introduced a credit derivative valuation tool earlier this year, which returns valuations based on the composite curves assembled from Markit’s consolidated price data. Subscribers, who can specify the use of alternative curves such as interpolated or flat credit derivative curves, plug in the terms of the relevant trades, and receive back the valuations.

"We introduced the tool in association with Markit, based on demand for independent valuations of credit derivative trades," says Blance at FT Interactive. IAS 39 accounting is one factor that has driven demand for the valuation tool, he says. "The types of clients that are using the tool include banks that are looking for regular valuations of their positions for risk management and for plugging into VaR models," adds Blance.

Reuters DataScope is also working on a credit derivatives valuation initiative. Mackelburg at Reuters DataScope says the need for good prices to meet NAV reporting deadlines is helping to drive the initiative. "A lot of dealers supply credit curves but supply them later in the day, so they are not ready for consumption in the 4pm timeframe for NAV," he says.

In addition to the derivatives markets, evaluated pricing providers are also forging alliances in the structured finance area. For example, Standard & Poor’s Securities Evaluations teamed up with cashflow modelling firm ABSxchange, to launch a European structured finance evaluated pricing service earlier this year.

Standard & Poor’s Securities Evaluations says the initiative marks the first extensive provision of evaluated pricing in the European structured finance market.

Says S&P’s Jones: "This is the first service to offer daily opinions of values across the capital structure of European securitised deals, including tranches rated below triple A and the thousands of outstanding deals that are illiquid and sensitive to prepayment."

The European ABS market is high on the list of priorities at other evaluated pricing providers. For example, Reuters DataScope is planning to launch an expanded European ABS evaluations service in 2007.

"European ABS is one of our chief initiatives for next year," says Mackelburg. "Already we have a good number of European contributors. We are receiving 5,000 quotes a day from market makers in Europe."

The European structured finance market is a prime example of a large, new growth area for evaluations services, as clients’ portfolios expand.

However, European structured finance brings plenty of challenges for evaluated pricing. Compared to North American securitisation markets, market infrastructure is weaker in Europe, and liquidity is generally thinner.

For example, surveillance and collateral data on securitisation issues is much less readily available in Europe.

Notes Mackelburg at Reuters DataScope: "In North America a lot of trustees are willing to share data and have it well organised. Loan level collateral data is sometimes more difficult to obtain. In those cases, relationships are particularly important."

Adds Blance at FT Interactive Data: "We believe there is a lot of scope for improving the transparency and timeliness of reporting in the structured finance area. It is a reasonably developed system in the US because of the homogenous nature of the market. That is not the case in Europe and Asia."

Modelling of prepayment speeds is another area where Europe is lagging North America, notes Jones at Standard & Poor’s Securities Evaluations. Benchmark prepayment speeds are not available in Europe.

Compared with European structured finance, structured credit is an ever bigger challenge for evaluated pricing.

"Structured credit is under discussion. We will solicit dealers for quotes but that is as far as we will go," says Mackelburg at Reuters DataScope. "These are private deals. Lack of information on the underlying collateral is a key problem."

As a result, independent valuations of structured credit look set to remain very much the domain of heavily model-based approaches. "Our approach is to model from first principles, using anything in the market that can help us to calibrate," says Christopher Rose, chief executive of Independent Valuation and Risk Services.

Rose says that hybrid CDOs of ABS are currently a big focus for the valuations business.

Credibility grows

Evaluated pricing remains a relatively new phenomenon in Europe, but a survey conducted by research firm A-Team Group suggests that the approach will continue to gain ground. Over two-thirds of the respondents to the survey, which was conducted last autumn, agreed that evaluated pricing is becoming increasingly accepted as a credible price source in ­Europe.

The survey found that regulations, together with a push by market data vendors in Europe is driving acceptance. Centralisation of data, which is encouraging data sharing between US and European business units, was listed as an additional factor.

The survey polled market participants such as fund managers, institutional money managers, broker/dealers and banks.