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