Friday, 25 September 2015

To outsource the pricing process or not?

Many companies still price their securities in-house. In theory this works well as long as the pricing routines pass quality checks by auditors, financial regulators and so on. Sometimes the best know-how  about the pricing dynamics can be found in-house due, for example, to local market knowledge or special illiquidity situations.

Over the past few years there has been increasing pressure to outsource pricing, however. This is due to a number of factors and it is in general easier for clients and potential clients/investors to accept the independence of prices used – for instance daily NAVS for a fund manager.

Thus externally set prices is turning into a best practice even for relatively simple-to-price portfolios, but this comes at a cost. You may end up with less hands-on work and so lose in-house knowledge. This may have the unfortunate consequence of also losing “counter-competence” to PMs when it comes to pricing and dynamics and ultimately having less risk control of the portfolio dynamics. Also external pricing could lead to operational errors that would have been avoided if price/product competence had been in-house.

Whether you should continue pricing yourself or outsource it all is therefore dependent on at least eight factors; 3 that are in favour and 5 that could be regarded as disadvantageous.

  1. It is increasingly common to fetch prices from external vendors (+)
  2. More objective and easier to accept for clients and other external parties (+)
  3. Evolving into a best practice (+)
  4. Desired to a growing extent by large consultancies, auditors and rating agencies (+)
  5. Possibly higher quality of the pricing (but the opposite may also be true) (+/-)
  6. Expensive (-)
  7. A loss of in-house knowhow and market understanding  (-)
  8. More illiquid and exotic instruments favour outsourcing (+)

If a company decides to outsource pricing, a due diligence and follow-up policy should be in place. The purpose of the due diligence review is to perform a full analysis of all elements of the outsourced provider with a view to identifying control weaknesses, systemic issues/risks, and anything which may result in a detrimental impact to the business and end client. There are different ways to approach this analysis from a controls testing bottom-up approach similar to an audit-style review through a higher level top-down assessment of the operational model to identify process weaknesses.

The best approach is probably to combine both methodologies to try and flush out any risk areas. By performing both you have a holistic view of the overall model and pressure points but with the audit style review at granular level you test the control activity that is taking place in practice.

Your due diligence of the external provider should look at all relevant areas of the outsourced function i.e. location, staff, control framework, etc.

Assign your own rating per element, for example (a) Does not meet standard, (b) meets standard, (c) best practice, or (d) not applicable. Clear annotation should be provided in each instance with a recommendation where applicable. An overall rating should be assigned for the provider’s service and the mechanics as to how this is derived should be clear to both parties. Post completion of the report and recommendations, the provider should be given an opportunity to review and provide feedback. It may be the case that an item has been misunderstood and inappropriately documented. Once an agreement on the report has been reached, it should be shared with the appropriate governance bodies and internal stakeholders. Finally all recommendations require specific target dates and to be tracked to ensure completion via regular forums in place according to the governance structure.

The due diligence should take place at least annually. However, the frequency should be semi-annual or more often if there is a high complexity in the portfolio to be priced, a high focus on the pricing issue or if the company has had recent pricing failure under for example IFRS or US GAAP that needed re-filing or public announcements combined with adjustments.

Henning Varner,
Risk Manager, SKAGEN Funds

The information, views, and opinions expressed in this blog are solely those of the author in person and generally do not reflect the views and opinions of SKAGEN Funds.

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