Fund managers are moving to get independent values on over-the-counter derivatives, rather than relying on their broker-dealers.

Just in the nick of time. "The financial crisis showed the fallacies of being dependent strictly on counterparties who had a vested interest in how the assets were valued," said Andy Nybo, director of derivatives research for TABB Group, a New York based research firm. "Coupled with the growing demands of investors and regulatory requirements for transparency, asset managers are turning to an array of fund administrators, valuation specialists and software vendors" to price derivatives such as credit default and interest-rate swaps.

In a recently published research report, Nybo estimates that in 2010, fund managers will account for about 30% of the $249 million that financial firms will spend in tapping valuation providers.

"Although fund managers are in need of independent valuations, their budgetary constraints will likely translate into far less spending than their larger sell-side counterparts," Nybo said.

The trend toward independent pricing is also gaining momentum due to the explosive growth of trading over-the-counter derivatives by traditional asset managers and pension plans. Their appeal is no longer limited to the more aggressive hedge funds. Some asset managers have hundreds or even thousands of derivative trades on their books they must value daily.

Valuing OTC derivatives is no easy task. The opaque and complex instruments that are linked to the movement of equities, interest rates, currencies and commodities are not traded on exchanges, so there is no consensus on just what the price should be. That leaves fund managers scrambling to find come up with answers.

Making matters more complicated for fund managers are the additional layers of disclosure that the U.S. financial reform bill passed in July-and other accounting regulations require. Currently, fund managers must also be able to comply with so-called fair value accounting regulations which require that they disclose just what methodologies and inputs they used to value all of their assets. That includes OTC derivatives.

Under the new financial reform legislation, "fund managers would be required to clear what are called 'standardized' contracts with clearinghouses, which in turn will need to publish the settlement price on a daily basis and value those assets," said Vinod Jain, managing consultant for the OTC derivatives practice at Headstrong, a New York based financial services consultancy. "The clearinghouses will then forward those prices to their clearing members so that sufficient collateral can be posted."

That means that the fund manager must reconcile the price it obtains from an independent source such as Markit, Numerix or Sophis with that of the clearinghouse. It must also reconcile that price with the price at which the transaction is executed through a so-called swaps execution facility or exchange. An estimated 60% of OTC derivatives are likely to be cleared through central clearinghouses, leaving the remaining 40% to be cleared bilaterally.

In either case, fund managers will need to rely on independent third-party valuations if for no other reason than it must show regulators and investors that it has done its due diligence in coming up with a correct valuation. And that its valuation is not based on self interest.

Which valuation provider to select is no easy task. "Fund managers shouldn't select any valuation provider randomly," said Charles Garcia, head of sales of Sophis, a New York-based risk management software vendor. "At the very least, they need to understand not only if the firm specializes in over-the-counter derivatives, but how long it has been doing valuations of those derivatives, and how many it values on a daily basis."

The greater the number of valuations, the more likely the valuation firm is to have encountered an array of vanilla and so-called exotic derivatives. But that's just the tip of the iceberg. Now comes the far harder part. Will the valuation provider disclose just how it values the over-the-counter derivative? That means what pricing models and inputs are used. The extent of that disclosure could be a deal-breaker.

"We avoid to the greatest extent introducing our own assumptions in our valuations and rely on observable data," said Matthew Berry, director in the portfolio valuations service at Markit, a London-based global financial information services firm specializing in derivatives and other OTC markets.

Markit relies on what is claims is the largest and most sophisticated set of raw data-such as credit and interest rate curves-around over-the-counter derivatives but also actual valuations from about 20 investment banks for credit default swaps and 50 market makers for interest rate swaps.

Other valuation providers such as Numerix will not only provide detailed information on how it values OTC derivatives but do it-yourself pricing models as well. Those are the off-the-shelf methodologies which firms can use to value over-the-counter derivatives but fall short of striking the actual prices.

"While smaller fund managers and administrators may use us to actually value portfolios because they don't have the in-house capabilities to process raw market data, many large asset managers simply rely on our models and do the valuations on their own," said Steve O'Hanlon, president of Numerix in New York.

Fund administrators also provide independent valuations, but those offering comprehensive product coverage sometimes aggregate data and analyze tolerances from multiple data & pricing vendors. GlobeOp, a New York and London-based hedge fund administrator says it values about 65,000 derivatives daily, using market standard models and data from over 20 recognized vendors.

Sophis has embedded its valuations into a service called Sophis Value, which allows fund managers to not only understand just how their OTC derivatives were valued but also how their valuations affect counterparty, portfolio and credit risk. In addition, fund managers can keep track of whether they comply with their investment guidelines.

"Such integration allows the firm to seamless perform additional necessary calculations and because the product is installed in the front, middle and back office, there is an enterprise-wide price," said Garcia.

"There are no differences in how the same contract is valued because the same inputs and assumptions are used," Garcia added.

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