Asset managers have tackled pricing issues for years. But what they haven't faced - until now - is a minefield of thinly-traded markets and unprecedented regulatory scrutiny. While the subject of pricing isn't new, it has never been more explosive - and the old way of running processes is being put to the test.

This latest wave of pricing pressure on the buy-side is being driven by the likes of the International Financial Reporting Standards for accounting (IFRS), which place tougher requirements on how complex derivatives are valued. Likewise, EMIR, Solvency II, and Dodd-Frank provisions are all putting transparency at the heart of the valuation process. We have also witnessed the FCA's 'Dear CEO' letter to asset management chiefs in 2012, warning them about the risks associated with outsourcing functions which are critical to regulated activities - which certainly includes valuations.

Indeed the problem of valuation has worsened recently in the bonds markets, following a period of shrinking liquidity. According to Federal Reserve data, only 1.8% of all bonds could be expected to trade on a given day as of Q2 2014, marking a 45% decrease from the 2004 tally.

This is why asset managers are reviewing how they establish valuations, and the level of diligence they apply to third party sources. As such, IPV is firmly in the spotlight.

The high price for errors

Compliance, however, is only part of the story. Accurate valuations drive accurate net asset value (NAV) for funds. The consequences of getting these wrong are severe: mistakes affect purchase and redemption transactions and cause mis-statements of fund performance. The operational effects are clearly problematic, but it is the reputational ramifications that are perhaps the most concerning and far-reaching. In the US, highly publicised mutual fund NAV errors have illustrated how considerable, and sometimes irreversible, reputational damage can be.

While many of these issues are not new, investor awareness of valuation issues exposed during the credit crisis has created a more urgent need for asset managers to look for accurate pricing. The problem is that coming up with an accurate valuation is no easy task.

Independent arbitration

This is why robust IPV is essential. It requires asset managers to access multiple evaluated price feeds from various external sources in order to analyze, compare and determine their own price. Price validation is also needed to ensure that any prices arriving through a data vendor, broker, or evaluated pricing supplier are reasonable and complete.

In the past, it may have been acceptable to rely on a single third-party source for pricing, but that's certainly not the case in today's compliance heavy landscape. Gathering data from just one vendor means there is no way of verifying the reliability of that source. Instead, the asset manager has to trust the feed completely, which carries a significant level of risk.

While some firms have built spreadsheets and manual processes to plug the gaps, these don't deliver the accuracy and transparency regulators and investors demand. It is up to the asset manager to evaluate feeds independently, for both easy- and hard-to-value instruments.

Redefining the rules

In order to validate the accuracy of feeds, asset managers need an approach that seamlessly connects to third party sources and applies sophisticated, pre-defined rules to compare feeds. This would allow them to remove speculation and, instead, arbitrate multiple prices in an unbiased way.

The degree of sophistication of these rules can be crucial, particularly for intricate OTC instruments and very thinly-traded bonds. Every input and assumption for evaluated pricing models must be documented and tracked, and wherever possible several vendor feeds, evaluated pricing models, and broker quotes for the same instrument must be considered. The price which ultimately gets selected must be tagged with its underlying source as well as documentation regarding how it was chosen. As a result, regulatory demands for a transparent process will be met.

Once on top of compliance, there are business benefits to be gained. By adopting this approach to independent pricing and valuation, an asset manager can avoid operational and reputational costs associated with miscalculations. Therefore, customers and prospects will have increased confidence in their ability to manage risk. As a result, an asset manager's reputation is enhanced, and new revenue opportunities will start to emerge.

Crucially, in a multi-asset market and a climate of reducing costs, IPV approaches must be accessible, easy-to-implement and able to handle any asset type, including exotic instruments. Asset managers have already shown that they are increasingly drawn to managed services offering quick deployment, and IPV should be no exception. It is entirely possible to deliver the benefits of accurate and transparent pricing with minimal impact.

The upshot is that with a quick and reliable route to performing IPV, the advantages far outweigh the challenges involved. Asset managers can be confident that they are reporting accurate prices, resulting in sound fund performance results. Perhaps the most important outcome is more loyal customers and confident investors, leading to positive reputations. And in a volatile and risk-conscious market, that is a precious and sometimes elusive trait.

Stephen Engdahl is the senior vice-president, product strategy, GoldenSource