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Tuesday, May 10, 2011

Pricing Transparency

Professor Allan Meltzer argues, in yesterday’s WSJ article BlackRock's 'Geeky Guys' Business, that BlackRock Solutions’s pricing process “should all be open” and that “[they] may be doing things honestly and above board, but we won’t see that unless we see how they got the numbers.”

While legislators and supervisors scurry to plug the holes created by the absence of both balance sheet and asset transparency, the final piece of the puzzle – pricing transparency – remains largely unattended to.

It is this final element, the lack of pricing transparency, that concerns Prof. Meltzer. Right now, hedge funds, banks and insurance companies can all carry the same asset at a different price. In illiquid markets, the price differential between two price providers can be extraordinary, creating an opportunity for lesser-regulated financial institutions to profit handsomely from the regulatory arbitrage available, at the expense of their more heavily-regulated counterparts.

As with “ratings shopping” where market participants seek the highest ratings on their securities, investors are financially incentivized to seek out the highest value they can find for each security. Funds’ performance (and often their managers' bonuses) is directly determined from the valuations of their assets. Stronger performance, whether real or artificial, can even help a fund or company raise new capital.

Thus, there remains significant potential for derivatives mispricing. One could even argue that the potential for mispricing is heightened when the price provider offers additional advisory services to the client. Given the substantial fees and margins that may be earned on the advisory side, a conflicted price provider may be more open to accommodating a client’s price haggling to win or maintain it as a client.

Prof. Meltzer’s goal for pricing transparency would hone in on, perhaps eliminate, numerous possible sources for deliberate mispricing (see list of contested pricings here). While we fear it may be prove an insurmountable hurdle to require pricing providers to share transparency as to their methods, we feel strongly that an opportunity exists now for market regulators to ensure the consistency of prices used. (See Central Pricing Solution here.)

Absent complete pricing transparency, the usage of consistent prices would serve to increase investor confidence as to the adequacy of financial institutions’ balance sheets. A requirement for all constituents supervised by the same regulatory body to apply the same price can discourage price haggling, or price shopping.

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