In 2016 the EBA established rules for the prudent valuation of financial instruments at fair value. Under the prudent valuation framework, institutions are required to calculate Additional Valuation Adjustments (AVAs) of their fair-valued financial instruments, which are intended to set valuations at a level that achieves an appropriate degree of certainty for prudential purposes. These adjustments are performed on a quarterly basis and are deducted from Common Equity Tier 1 capital as per Article 34 of Regulation (EU) No 575/2013. Since its introduction, the regulation has aimed to standardise valuation practices, although some variations remain. The European Banking Authority (EBA) has reviewed the framework and found room for improvement. In January 2024 the EBA began a three month consultation for Amending Draft Regulatory Technical Standards on prudent valuation under Article 105(14) of Regulation (EU) No 575/2013.
In 2016 the EBA required AVAs to be calculated using three different methods (in order of seniority). These are broadly defined as:
- Range-based (Article 9.5.a.i) – there is sufficient market data and information (exit and mid prices) available to perform accurate valuations and associated AVAs with 90% confidence.
- Expert-based (Article 9.5.a.ii) – there is insufficient market data and information available to generate a range of valuations. Institutions are required to use independently verified methodology on other available, reliable data (e.g. modelled data and their parameters or proxies) to generate valuations. This approach often amounts to larger AVAs and will entail higher levels of oversight and reporting.
- Fall-back approach – no, or very limited data, is available to determine AVAs and a conservative approach to valuation risks must be taken. This may be in the case of legacy trades and the approach is often only used for a very limited number of positions.
After 8 years of enforcement the EBA have decided that improvements can be made to the existing Regulatory Technical Standards. Notably, the EBA observed that some of the data sources used in the range-based approach were not proving to be as accurate as hoped and thus the expert-based approach should have been employed. As such they have proposed a hierarchy of data sources to be used in each approach within the Draft RTS.
Within the consultation the EBA has made a number of proposals relevant to IPV and consensus pricing.
- [Article 1] Institutions will be required to calculate fair values and AVAs with a monthly frequency.
- [Article 3.2] Institutions shall consider a full range of available and reliable market data to determine a prudent value using one or more of the following market data sources:
- exchange prices in a liquid market;
- trades between parties at arm’s length in the exact same or very similar instrument, either from the institution's own records or, where available, trades from across the market;
- tradable quotes from brokers and other market participants;
- consensus service data where the number of contributors is greater than or equal to 10 and the institution has performed valuation back testing (i.e. confirmed that the data from this source is consistent with actual market transactions).
- [Article 3.3] Where institutions apply an expert-based approach in accordance with Articles 9(5), point (a)(ii), 10(6), point (a)(ii) and 11(4), they shall consider additional methods and sources of information, including, where relevant, the following:
- consensus service data not meeting the conditions in paragraph 2, point (d);
- indicative broker quotes;
- counterparty collateral valuations;
- the use of proxy data based on similar instruments for which sufficient data is available;
- the application of prudent shifts to valuation inputs;
- the identification of natural bounds to the value of an instrument.
Skylight IPV was thankful to be able to respond alongside other industry institutions. After collating the public responses† the popular opinion can be summarised as following:
- The EBAs 2024 Draft Regulatory Technical Standards are overly prescriptive while at the same time leaving many points open to interpretation.
- The stricter rules suggested in the Draft RTS puts European institutions at a disadvantage to their US and UK counterparts.
- Calculating AVAs on a monthly frequency can be operationally challenging and increases expenses associated with higher personnel and resource requirements.
- A consensus with a minimum of 10 contributors seems to be arbitrarily chosen and is unhelpful for a number of reasons:
- There is no correlation between the quality of a consensus and the number of contributors;
- You can feasibly have the scenario where for one reporting date you can use the range-based approach as you have 10 contributors and on the next, where you have dropped to 9, you have to use the expert-based approach;
- A threshold of 10 is anti-competitive and favours established consensus providing services at the expense of emerging services;
- It incentivises consensus providers to search for additional contributors at the expense of the quality of the data;
- Some markets only have less than 10 active participants. A consensus comprised of 100% of the market participants, even if there are less than 10, backed up by trade and quote data would provide accurate and reliable information;
- If there are 10 contributions but one is incorrectly marked there will be an incentive for the consensus provider to create a mechanism so that the contribution is counted, but does not affect the consensus, range and other statistics.
With regards to Indicative and Tradable quotes there were a number of comments including:
- It is often not possible to distinguish between indicative and tradable meaning some reliable quotes end up classified as indicative;
- Tradable quotes can have negligible size and not be representative of the market;
- Excluding indicative quotes from the range-based approach would lead to dominance of the expert-based approach since proof of tradability for broker quotes is rarely possible;
- In some markets it is standard practice to quote indicatively. The bond market only has indicative quotes as the market trades OTC. Market-makers’ quotes provided on this OTC market would be classed as indicative as they are not legally-binding. Henceforth, the expert-based approach would have to be employed;
- Broader consideration should be given towards allowing indicative quotes and consensus in the range-based approach.
We will continue to keep you up to date with this and other regulatory topics affecting IPV and consensus pricing. If you have any comments please do contact us at info@skylightipv.com.
Lee Davies