What is Independent Price Verification (IPV)?
The principle behind Independent Price Verification is ensuring independence in the valuation process between risk taking and control units, establishing a set of controls to ensure front office marks are validated/verified independently. This means that prices used by Front Office systems, and hence the risk taking units, must be independently verified by the Risk Control Unit. IPV is the process by which market prices or inputs are verified for accuracy and must be performed by the Risk Control Unit.
Independent Price Verification requirements form part of several regulations and standards. Basel II Prudent Valuation Guidance defines Independent Price Verification as “the process by which market prices or model inputs are regularly verified for accuracy. While daily marking-to-market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly (or, depending on the nature of the market/trading activity, more frequently)”.
Gold Copy Market Data
Many firms implement a process to produce a “gold” copy of market data for use in Front Office systems to ensure valuations and risk calculations are based on high quality market data and issues – such as gaps and spikes – are addressed before use.
In some cases, ownership of the gold copy and the rules and data sources used has been passed to Risk Control so that the Front Office has limited control over the model inputs. These data areas are clearly defined by Risk Control with appropriate controls in place to ensure they are covered by the IPV process. Typically, Front Office would retain responsibility for data difficult to source from vendors or infrequently updated.
Ensuring all Front Office systems use a centralized gold copy eliminates market data as a cause of valuation differences between systems.
Risk Control Ownership of Market Data
When the Risk Control unit owns the gold copy process, the IPV process can be concentrated on the limited market data that Front Office has control over, but the IPV process must ensure the completeness of the checks.
These might include:
- Monthly checks against market consensus data – with P&L impact reported based on valuations or risk sensitivities.
- Daily checks on any market data overridden within a Front Office system. Any overrides are reported and controlled with expiry dates/comments to explain the use of the override and assess the P&L impact.
Front Office Ownership of Market Data
When the Front Office retains control over market data, all data must be verified. This means that Risk Control must establish a process to create a centralised copy of reference data to use in the IPV process.
Managing the IPV Process
Risk Control own the IPV process and are responsible for establishing a range of steps and activities that define the process. These should include:
- Market data sources and rules
- Frequency and completeness of checks
- Reconciliation against Front Office systems using risk control tolerances
- Exception handling
The diagram below shows a typical IPV process workflow, each step of which should be controlled and audited as part of the governance framework.
Best practice IPV workflows and governance framework
As reporting will often materially affect the P&L impact, efforts should be made to identify and quantify the extent to which this is the case. This can be assessed by:
- Revaluation in the Front Office system using a set of reference prices produced by Risk Control.
- Using risk sensitivities provided by Front Office systems and the difference in prices between the Front Office and Risk Control prices within the risk control system.
- A hybrid combining the above (e.g. Monday to Friday a risk sensitivities approach in the risk control system is used but at the weekend the additional time allows for a full revaluation in the front office system. The full revaluation would also act as a check on the sensitivities approach).
Governance and Review Structure
To ensure adequate governance of the reconciliation, the IPV process must be part of an integrated control framework within an organisation and should be linked with the review structure for model valuations and processes. Actions should be audited and all data must be traced from its source through the process.
Implementing robust controls and governance around the valuation process not only avoids the operational and reputational costs of miscalculations. It also means that clients can have confidence in the trading and risk management capabilities of the firm and, more importantly, that the organization is basing its business decision on reliable information – something about which both the regulator and the shareholders would approve.