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Today’s Vital Need for Transparent Valuations
by Bob Park, President and CEO, FINCAD
A worldwide re-examination of reporting fair values is under way by policymakers, standard-setters and those who must comply. The rise in prominence of risks, such as the counterparty credit risks inherent in holding derivatives, have spurred an era of reform and rethinking for all.
This has prompted treasurers to analyse financial risk exposures in entirely new ways. Further requirements to measure and disclose risks are imminent, but the practical aspects of how to measure, manage and disclose risk have yet to arrive at common answers. The market recognises risk, so it demands that risk be measured. Metrics such as Maximum Peak Exposures and Credit Value Adjustments are becoming better understood out of necessity.
Solution vendors are always eager to please when new needs emerge or old needs intensify, but what are the characteristics of a good solution for risk and compliance, and why is transparency key? The demand for openness is emerging in all aspects of regulatory reform and the rethinking of risk. Closed systems that perpetuate valuation risk will be challenged as corporate risk awareness and compliance capacity are scrutinised. The best practices of the future will be open, transparent and easily defended.
Whether corporate derivative transactions are for operating, financing or investing purposes, we now live in a world where the credit standing of your counterparties and your own standing are increasingly critical to the transparent valuation of corporate portfolios. When derivatives are held, counterparty risks are taken, and it is preferable to measure and account for such risks.
Closed systems will increasingly be deemed incomplete or even obsolete as more stringent disclosures are required.
There may have been a time when trading a particular derivatives position with one major counterparty was not much different from trading with another. There was an unspoken assumption that large houses were generally safe: corporations implicitly agreed with that assessment and did not question their counterparties as rigorously as they are doing today.
Many treasuries now systematically spot check or comprehensively check their counterparties’ derivative pricing by conducting independent valuations, if they did not do so before.
It is now recognised that the risks behind major financial institutions were not fully transparent, nor were counterparty risk positions fully understood. If the risks were fully understood, the level of systemic speculation was grossly understated by an entire industry. The world now knows it is possible to fully realise the risks of major counterparties, and more transparent disclosures of the processes and methods behind the positions that were taken might have helped in foreseeing or mitigating some of those risks.
Losses exacerbated by non-transparent disclosures and by the veil of proprietorship continue to echo through the corporate world, and underlie much of the US Congressional debate about regulatory reform and IASB initiatives towards reform. Such losses can become apparent in certain types of securities, such as mortgage-backed securities, or through the failure of counterparties to perform on their own losing side of a derivatives contract. Perhaps most telling of all is the devastating systemic impact that the failure of a single major counterparty can have on entire markets. With the understanding that asset classes can suddenly lose their liquidity, the demand for clear disclosure has never been more apparent.