Interactive Data Wins Patent for Fair-Value Pricing

 

By Chris Kentouris

March 26, 2007

 

Interactive Data Corp. is the latest to claim a place on the business-method patent bandwagon, saying last week that its pricing and reference data business has obtained one from the U.S. Patent and Trademark Office for a fair-value pricing system.

 

Fair valuation is the process of determining the proper price of a security that may be thinly traded or illiquid--hence not having a market price readily available--or in cases where "significant events" may have occurred between the posting of a market price and the need for a fair-value peg. Foreign stocks pose such challenges because they trade on exchanges that close hours before 4:00 p.m. Eastern time in the U.S., when fund managers price their portfolios to publish a net asset value.

 

According to Peter Ciampi, a market analyst at Interactive Data and the designated co-inventor of the patented methodology, it is based on multifactor regression analysis that "takes into account shifts in the S&P 500 as well as changes in industry sectors and currency fluctuations in providing a best estimate of what a security is worth." Ciampi's co-developer was Eric Zitzewitz, assistant professor of economics at Stanford Graduate School of Business and a consultant to Interactive Data.

 

Financial services firms and technology vendors, among others, have been filing for and obtaining patents for business methods in large numbers since 1998 when State Street Corp. won a landmark court case centering on a mutual fund service. Bedford, Mass.-based Interactive Data filed for its patent in April 2001, a year before launching its Fair Value Information Service, which currently values nearly 20,000 securities daily for more than 145 clients including many major mutual funds.

 

Interactive Data, which recently unified its corporate identity after using FT Interactive Data and other brand names, isn't the only seller of fair-value pricing. Ciampi says that other predictive systems have patents, but that Interactive Data's "unique feature" is estimating rather than predicting the value of a security when it is not trading. Officials at a competitor in the field, Investment Technology Group (ITG) in New York, were unavailable for comment.

 

Regulatory Matter

 

Fair valuation has been on the radar screen of the mutual fund industry and its regulators in the wake of market-timing abuses that came to light earlier in the decade. Buy-side firms' directors have long been accountable for fair valuation when market prices are not readily available, but in an April 2001 letter to mutual fund trade group Investment Company Institute, the Securities and Exchange Commission recommended that funds take into account "significant events" when arriving at fair-value prices.

 

Further SEC guidance in 2004 said that fund registration documents must explain the circumstances under which the funds will utilize fair-value pricing. The SEC left it up to each fund group's board to draft policies and procedures that are adequate for their own funds. Chief compliance officers are responsible for testing the processes and reporting on their reliability.

 

Although fair-value pricing may not be an exact science, the need for vigilance has been brought home to asset management firms. "The mutual fund industry is much more careful about fair-value pricing and is relying on a combination of internal resources and outsourcing agents," says Mark Sunshine, president of First Capital, a financial services firm in West Palm Beach, Fla.

 

In a 2006 survey by Deloitte & Touche of 77 asset managers who advise more than 3,500 funds with a total of $3 trillion in assets under management, 74 percent of respondents said they used third-party vendors for pricing foreign securities. Fifty-six percent of all respondents, and 71 percent of those at firms with more than $75 billion in assets under management, evaluated prices from third-party vendors each day a price is provided as part of their monitoring procedures.

 

Even when firms tap outside fair-value vendors, it is ultimately up to the management and its board to decide exactly what events will trigger these calculations, whether a fund wants to fair-value some or all securities at various times, or whether to take no action at all even if a trigger occurs. Methodologies vary, and fund companies know not to take any third-party prices without scrutiny.

 

"In the case of foreign equities, we send our mutual fund clients opening prices on exchange-traded securities each day so they can back-test the correctness of fair-value prices offered by Interactive Data and ITG," says Alexander Ramos, managing director of mutual fund accounting and administration at Bank of New York.

 

Mutual funds rely on fair-value pricing as one of the means to curtail the ability of day traders to take advantage of the way mutual finds calculate net asset values by buying and selling foreign shares after the close of the local market but before the close of the U.S. market. Many funds have also imposed redemption fees and use monitoring technology to flag suspicious transactions.

 

Short-term trading can seriously affect the profit margins of a mutual fund and pose a disadvantage to longer-term investors, particularly in Asia-Pacific-centered funds whose prices are most closely pegged to the U.S. market.

 

Fixed-Income Issues

 

While foreign securities may have received the most widespread attention for fair-value pricing, they aren't the only asset class subject to valuation problems. "Fund companies are also challenged in pricing some fixed-income securities and over-the-counter derivatives, which have their own characteristics," says Sunshine of First Capital.

 

Interactive Data confirmed that in 2004 it settled a case--without admitting or denying wrongdoing--in which it allegedly allowed mutual fund company Heartland Advisors to influence its bond-valuation decisions.

 

In the Deloitte survey, more than half of fund firms used some type of internal analysis to assess the reasonableness of counterparty quotes, and more than a third of those firms reported detecting errors in those counterparty quotes for non-exchange-traded derivatives contracts.

 

Comprehensive outsourcing services for debt instruments are lacking, says Ramos, leaving funds to price on an ad-hoc, individual-security basis.