A French Slant on Valuation
October 28, 2010
Last Thursday, I went along to an event organized by the Club Finance Innovation on the topic of “Independent valuations for the buy-side: expectations, challenges and solutions”.
The event was held at the Palais Brongniart in Paris, which, for those who don’t know (like me till Thursday), was built in the years 1807-1826 by the architect Brongniart by order of Napoleone Bonaparte, who wanted the building to permanently host the Paris stock exchange.
Speakers at the roundtable were:
- Eric Benhamou, CEO Pricing Partners
- Francis Cornut, Président DeriveXperts
- Jean-Marc Eber, Président LexiFi
- Patrick Hénaff, Associated Professor at the University of Bretagne (see model validation paper for additional background)
- Claude Martini, CEO Zeliade Systems
The event focussed on the role of the buy-side in financial markets, looking in particular at the concept of independent valuations and how this has taken an important role after the financial downturn. However, all the speakers agreed that remains a large gap between the sell-side and buy-side in terms of competences and expertise in the field of independent valuations. The buy-side lacks the systems for a better understanding of financial products and should align itself to the best practices of the sell-side and bigger hedge funds.
The roundtable was started by Francis Cornut of DeriveXperts, who gave the audience a definition of independent valuation. Whilst valuation could be defined as the “set of data and models used to explain the result of a valuation”, Cornut highlighted how the difficulty is in saying what independent means; there is in fact a general confusion on what this concept represents: internal confusion, for example between the front office and risk control department of an institution, but also external confusion, when valuations are done by third-parties.
Cornut provided three criteria that an independent valuation should respect:
- Autonomy, which should be both technical and financial;
- Credibility and transparency;
- Ethics, i.e.: being able to resist to market/commercial pressure and deliver a valuation which is free from external influences/opinions.
Independent valuations are the way forward for a better understanding of complex, structured financial products. Cornut advocated the need for financial parties (clients, regulators, users and providers) to invest more and understand the importance of independent valuations, which will ultimately improve risk management.
Jean-Marc Eber, President LexiFi, agreed that the ultimate objective of independent valuations is to allow financial institutions to better understand the market. To accomplish this, Eber pointed to the fact that when we speak about services to clients, we should first think of what are their real needs. The bigger umbrella of “buy-side” implies in fact different needs and there is often a contradiction on what regulators want: on one side, having independent valuations provided by independent third parties; on the other side, independent valuations really mean that internal users/staff do understand what there is underline the products that a company have.In the same way, we don’t just need to value products but also measure their risk and periodically re-value them.It is important, in fact, to have the whole picture of the product being evaluated in order to make the buy-side more competitive.
Another point on which the speakers agreed is traceability: as Eber said, financial products don’t exist just as they are, but they go under transformation and change several times. Therefore, the market needs to follow the products across its life cycle till its maturity stage and this pose a technology challenge, in providing scenario analysis for compliance and keeping track of the audit trail.
At the question, ‘what has the crisis changed’ panellists answered:
Eber: the crisis showed the need to be more competent and technical to avoid risk. He highlighted the need to understand the product and its underlying. Many speak of having a central repository for OTCs, obligations, etc but this needs more thinking from the regulators and the financial markets. Moreover, the markets should focus more on quality data and transparency.
Eric Benhamou, CEO pricing Partners, sees an evolution of the market as the crisis showed underestimated risks which are now being taken in consideration.
Claude Martini, CEO Zeliade, advocated the need for financial markets to implement best practices for product valuations: buy-side should apply the same practices already adopted by the sell-side and verify the hypotheses, price and risk related to a financial product.
Cornut admitted things have changed since 2005, when they launched DerivExperts and nobody seemed to be interested in independent valuations. People would ask what value they would get from an investment in independent valuations: yes, regulators are happy but what’s the benefit for me?
This is changing now that financial institutions know that a deeper understanding of financial products increases their ability to push the products to their clients. The speech I enjoyed the most was from Patrick Hénaff, associated professor at the University of Bretagne and formerly Global Head of Quantitative Analysis – Commodites at Merrill Lynch / Bank of America.
He took a more academic approach and contested the fact that having two prices to confront is thought to reduce the incertitude on the product but highlighting as this is not always the case. I found interesting his idea of giving a product price with a confidence interval or a ‘toxic index’ which would represent the incertitude about the product and reproduce the model risk which may originate from it.
We speak too often about the risk associated to complex products but Hénaff, explained how the risk exists even on simpler products, for example the calculation of VAR on a given stock positioning. A stock is extremely volatile and we can’t know its trend; providing a confidence interval is therefore crucial. What is new instead, it is the interest that many are showing in assigning a price to a determinate risk, whilst before model risk was considered a mere operational risk coming out from the calculation process. Today, a good valuation of the risk associated to a product can result in less regulatory capital used to cover the risk and as such it is gaining much more interest from the market.
Henaff describes two approaches currently taken from academic research on valuations:
1) Adoption of statistic simulation in order to identify the risk deriving from an incorrect calibration of the model. This consists in taking historical data and test the model, through simulations and scenarios, in order to measure the risk associated in choosing a model instead of another;)
2) Have more quality data. Lack of quality data implies that models chosen are inaccurate as it is difficult to identify exactly what model we should be using to price a product.
Model risk, which as said above was before considered an operational risk, now becomes of extremely importance as it can free up capital. Hénaff suggested that is key to find for model risk the equivalent of the VAR for market risk, a normalized measure. He also spoke about the concept of a “Model validation protocol”, giving the example of what happens in the pharmaceutical and biologic sectors: before launching a new pill into the market, this is tested several times.
Whilst in finance products are just given with their final valuation, the pharmaceutical sector provides a “protocol” which describes the calculations, analysis and processes used in order to get to the final value and their systems are organized to provide a report which would show all the deeper detail. To reduce risk, valuations should be a pre-trade process and not a post-trade.
This week, the A-Team group published a valuations benchmarking study which shows how buy-side institutions are turning more and more often to third-parties valuations, driven mainly by risk management, regulations and client needs. Many of the institutions interviewed also admitted that they will increase their spending in technology to automate and improve the pricing process, as well as the data source integration and the workflow.
This is in line on what has been said at the event I attended and confirmed by the technology representatives speaking at the roundtable.
I would like to end with what Hénaff said: there can’t be a truly independent valuation without transparency of the protocols used to get to that value.
Well, Rome wasn’t built in a day (and as it is my city we’re speaking about, I can say there is still much to build, but let’s not get into this!) but there is a great debate going on, meaning that financial institutions are aware of the necessity to take a step forward. Much is being said about the need for more transparency and a better understanding of complex, structured financial products and still there is a lot to debate. Easier said than done I guess but, as Napoleon would say, victory belongs to the most persevering!