SECs new valuation rule 2a-5 mandates greater pricing transparency

This article was written by Brad Foster, Regulatory & Accounting Products and Reference Data at Bloomberg and Scott Coulter from Bloomberg’s Regulatory & Accounting Products group.

What’s in a price?

It’s a question that has often confounded investors and regulators alike. Pricing methodologies differ across regions, industries and asset classes. As the scope of financial instruments ballooned over the past few decades, the challenge of pricing this universe of instruments became increasingly daunting and created greater difficulties in regulating pricing.

Regulatory bodies of all types have been grappling with how to better police these prices and provide investors and other stakeholders with much needed transparency into the composition of the price.

The SEC became the latest regulatory body to support greater pricing transparency in December when it voted to adopt proposed rule 2a-5. The new rule establishes an updated regulatory framework for fund valuation practices and focuses on funds that fall under the scope of the Investment Company Act of 1940 (so-called “40 Act funds”).

With a tight timeline and extensive requirements, the new rule presents challenges and questions for how impacted firms will get on board, especially those with extensive fund portfolios or opaque pricing methodologies.

The new rule is the latest step in a broader push for further transparency and regulation on pricing methodologies and inputs. While the current proposal is limited to 40 Act funds, it doesn’t take a lot of imagination to see the change as part of a growing trend and to expect many of these requirements to eventually move beyond 40 Act funds to other types of funds and financial institutions.

An updated regulatory framework for fund valuation

The framework for fund valuation has not been amended in over 50 years and requires changes to address the fact that funds have become more prevalent with retail investors. At the same time, funds have moved into less liquid, lower quality issuers in search of yield as interest rates remain low and credit spreads continue to tighten. Fund holdings have become more diverse and fund managers have increasingly come to rely on third party pricing services.

Additionally, there have been drastic increases in the breadth of instruments trading in the market and an increase in both the volume and type of data available for making valuation determinations.

Rule 2a-5 focuses heavily on the use of “good faith” for the purposes of an objective, transparent and defensible process for determining the fair value or price of an investment, whether that determination sits with the organization itself or a third party. It requires, among other things:

• Assessing and managing material risks associated with fair value determinations
   

• Establishing and applying fair value methodologies
   

• Testing (e.g. back-testing or calibration) fair value methodologies
   

• Evaluating any pricing services used
   

• Adopting and implementing fair value policies and procedures
   

• Maintaining extensive records related to fair value determinations

Alignment with accounting principles

Much of rule 2a-5 borrows concepts first introduced in ASC 820 (2006) and IFRS 13 (2007). These standards define the accounting concept of “fair value” for the purpose of pricing instruments for financial statements and implement a simple, crude framework for classifying instruments as Level 1, 2 or 3 based on the observability of the price or pricing inputs in the market (so called “Fair Value Levelling”). Rule 2a-5 expands on these rules by providing a framework for compliance.

From ASC 820 and IFRS 13, rule 2a-5 borrows the concept that prices must be an objective assessment of fair value. The new rule also requires consideration of whether a price is “readily available”, which aligns with the accounting requirement that a fair value be “readily determinable”, which is defined as being met “if sales prices or bid-and-asked quotations are currently available” in an active market.

Further, it aligns with the Level 1 investments in the Fair Value Leveling framework in both accounting standards.

How to prepare for the road ahead

The SEC is proposing a one-year transition period upon adoption of the proposed rule. That could be viewed as a long or short transition period depending on an organization’s current process.

Complying with the requirements of rule 2a-5 starts with a wholesale review of an organization’s existing pricing process, with special emphasis on any portion of that process which relies on third parties.

Significant attention needs to be given to whether current procedures meet the requirements that organizations use “good faith”, “readily available”, and objective prices and pricing methodologies. Whatever your current process, rule 2a-5 is likely to cause some increased burden when it comes to documenting procedures and policies, evaluating and backtesting processes, and maintaining adequate documents and records of these elements.

A prudent starting point would be to perform a gap assessment to the proposed regulation and to better understand how your existing pricing methodologies line up with the criteria above.

It is imperative that organizations and Boards maintain robust pricing procedures and policies, and continually monitor these processes for creeping risks and subjectivity.

The simple defense to this and other regulations is to continually ask, “What’s in our prices?” and whether clients and investors have access to the answers to that question as well. Compliance with rule 2a-5 will require transparent prices with granularity into what constitutes that price. It requires partnering with third party pricing providers with robust policies and procedures in place. 

Bloomberg’s Evaluated Pricing Service (BVAL)

Bloomberg’s BVAL service supplies independent and transparent evaluated pricing daily for over 2.5 million securities across all asset classes, including thinly-traded and hard-to-price fixed income securities.

BVAL Transparency Data

BVAL details and explains every step in the valuation process and provides insight into the data inputs and algorithmic methodologies used so firms can justify all aspects of how pricing valuations are derived. Bloomberg valuations are also supported by the BVAL Score, a proprietary measure showing the relative amount and consistency of market data used to generate each evaluated price.

Find more information, visit the Bloomberg BVAL webpage.