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By Magnus Cattan, Head of ICE Data Services (Asia-Pacific)

The new ‘fair value’ rules are a response the 2008 credit crisis, when many financial firms were unaware of growing losses in their portfolios. That period also underscored the risk of counterparty exposure, when the default of several financial institutions and their contagion effect sent ripples through the financial system.

Compared to the U.S. and Europe, Japan was less severely affected by the 2008 credit crisis and did not implement updates to fair value measurement standards afterward. The central bank’s negative rate policy also prompted many financial firms to seek yield by holding more sophisticated, less liquid assets. This includes domestic privately placed RMBS and structured notes. Given the lack of transparency in these markets, many Japanese institutions particularly buy-side firms, may have historically relied on their counterparty as a single source of regular valuations for these products. Additionally, to hedge assets to meet liabilities, these financial firms commonly hold relatively large OTC derivative portfolios.

Now, Accounting Standards Board of Japan (ASBJ) requirements for Fair Value Measurement mean Japanese firms must reassess the value of their portfolios, including OTC assets such as fixed income and derivatives.

These principles are broadly in line with IFRS13, which defines fair value as ‘the price that would be received to sell an asset, or paid to transfer a liability in an orderly transaction between market participants at the measurement date’.

Greater disclosure on the sources and methods to calculate fair value include the need for a “leveling” table which calls for financial assets and liabilities to be classed on a scale according to IFRS13 and ASBJ requirements:

• Level 1 is quoted prices for identical items in active liquid markets such as stock exchanges.
• Level 2 is observable information for similar items in active or inactive markets, such as similar buildings in a specific real estate market.
• Level 3 are unobservable inputs where markets don’t exist or are illiquid - making fair market valuation very subjective on model parameters and inputs.

To help firms meet these reporting requirements, ICE Data Services (IDS) offers a Fair Value Hierarchy service across all global asset classes. Utilising ICE Data Pricing & Reference Data’s evaluations and reference data, our rules engine applies IDS’s market data and observable pricing inputs to calculate an instrument’s ‘level’ based on client-configurable rule sets. In this way, users can gain visibility into how instruments may be classified, and the inputs which determine this classification.

Counterparty risk

The solvency of counterparties in financial transactions is key to determining credit risk.

Credit Valuation Adjustment (CVA) adjusts derivative transaction pricing based on the credit risk of its counterparty - or the potential credit loss from that counterparty exposure. Debt Valuation Adjustment (DVA) or the company’s own credit risk, reflects potential gain for not having to pay its liability if a default occurs.

ASBJ fair value standards have encouraged both accounting DVA and CVA to be measured and disclosed. While large domestic and international banks in Japan have reported CVA for several years, many smaller institutions like regional banks and insurers have not priced this risk into their transactions. This creates the need for additional investment in data and financial engineering tools to appropriately capture and risk manage counterparty risk.

ICE Data Derivatives offers mark-to-market services across the derivatives asset classes and a CVA/DVA calculation services to help support a range of accounting, regulatory and trading needs. Designed for quarterly, monthly or daily reporting requirements, it applies ICE Data Derivatives’ proprietary derivatives market data, including CMA CDS Group Curves that are used as Proxy Curves in CVA calculations.

A global challenge

While U.S. and European firms have had longer to adjust to Fair Value rules, differing interpretations of the requirements persist. This means many companies continue to grapple with shifting auditor requests for data, and look to independent parties for verification of their inputs.

While circumstance has enabled Japan to take a ‘wait and see’ approach, the deadline for compliance is fast approaching. Global vendors like ICE Data Services serve clients across the world, offering the benefit of experience - and the ability to tailor solutions to help support continued innovation throughout Japan’s financial sector.