A Case for Automation While Trading Structured Credit
Our last two blogs on structured credit covered in detail the ever-evolving complexities involved in pricing structured instruments, especially during the pandemic. Luckily, these complexities can be managed with the introduction of automation to improve efficiency and transparency throughout the pricing process, thus leading to the generation of alpha. There are several areas within the pricing process that can be streamlined and automated as indicated below:
- Quotes from Pricing Vendors & Brokers: A lot of vendors provide pricing quotes on both a daily and monthly basis via multiple modalities including email, FTP, API, etc. We have even observed that the same source can send quotes via different mechanisms at various points throughout the day depending on the asset class, which makes it hard to maintain and track on a day-to-day basis. Dealing with such a multitude of sources is a manually-intensive exercise that requires an additional amount of dedicated effort from pricing teams. In fact, it calls for end-to-end automation of consuming pricing quotes to allow the team to better focus on the actual pricing activity rather than reaching out to different sources for prices.
- Managing Spreadsheets, Finalizing Marks & Reporting: Every day, the pricing team must manage a plethora of pricing quotes and run various pricing tests to decide the final marks before a defined timeline. While most of this is done manually through spreadsheets, it becomes more tedious and inefficient in cases when it must be managed collaboratively by the team across geographies. This also introduces a risk around transparency, proper auditing and timely reporting. However, an automated tool can maintain data in a structured way, thus providing seamless access for the entire pricing team with a complete audit and time-series view. It will also come with an added capability of managing the pricing waterfall, pricing exceptions (tests) and out-of-the-box automated reporting to accelerate the entire process.
- Price Challenges: During the pricing process, especially at month-end, a typical fund will challenge between 10% and 30% of quotes for their structured book. The overall process, starting with the initiation of challenges and subsequently tracking and updating prices with revised quotes, adds up to be a significant burden on the pricing team, making it difficult to keep up with revisions. This becomes extremely difficult in cases where the challenge request and response needs to be communicated in a defined way, requiring manual submissions and their tracking. With that being said, an efficient way to streamline the entire challenge process is to set up an automated challenge mechanism to initiate, send, track and consume the challenge response all within one system that also provides users with a sound notification/alert feature and complete audit.
- Recording Input Variables & Performing Sensitivity Analysis: Pricing structured instruments involves a strong validation process through internal models and data points, requiring additional inputs of data that range from volatility curves, forward prices, interest rate curves and much more. These data points help the team to perform scenario analysis and discover the right price using an appropriate model to provide validation against other available quotes. Managing these underlying curves and maintaining their data points overtime becomes quite the overhead for the pricing team. In order to significantly simplify this task, an automated tool can be implemented to help with consumption, storage and visualization while leveraging the capability to post these points to various internal and external models. Overall, this can help the pricing team regress various inputs and understand their impact on the prices of structured instruments.
- Cross-Platform Integration: Oftentimes, the output from the pricing process must be shared with other systems to generate insights and useful information like risk metrics, NAV, sensitivity analysis, etc., making it vital to establish seamless, real-time connectivity with both the upstream and downstream pricing system. This can be achieved through an automated pricing application that can connect with other in-house or vendor systems via multiple modalities like email, FTP, API, etc.
Due to all of these factors, an increasing number of funds are looking for ways to streamline the pricing of structured instruments through the use of better data and more efficient tools.
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