On 16 November 2009 Nomura International was fined £1.75 million for breaches of Financial Service Authority principles. The specific principles were Principle 2 – failing to conduct its business with due skill, care and diligence, and Principle 3 – failing to take reasonable care to organise and control its affairs responsibly and effectively. The area of valuations of exotic products is now at the fore of the regulator’s attention. The global financial crisis exposed significant weaknesses in the risk management practices of many funds and banks. Investors and regulators are now demanding that the investment banks and the asset management industry implement far stronger risk management processes, including OTC valuation. In respect of the asset management industry, their concerns are illustrated by the EU’s inclusion of requirements for funds to provide far better risk management reporting in the UCITS IV Directive and the draft Alternative Investment Fund Management (AIFM) Directive.

The Nomura case
Nomura discovered incidences of mismarking and mounted its own internal investigation, appointing outside consultants to review this area; the original mismarking was an overvaluation of £10.8 million. The FSA view on such matters is clear. “The FSA considers that firms should take care to price financial instruments correctly. Particular care must be taken to price derivatives and other complex products accurately and ensure that individuals with a potential incentive to mis–mark are properly controlled. The FSA considers the proper functioning of an independent price verification process to be a vital element in this task. If a firm does not have the resources or institutional experience adequately to supervise an activity it should not undertake it.” Nomura had set up a worldwide equity derivatives business with centres in New York, Hong Kong and London. Trading was done for the firm’s own account and on behalf of clients, and Nomura also issued structured equity products to high net worth individuals via private banks. Traders were required to mark their books for certain variables including implied volatility, correlation and dividends. These parameters need to be monitored effectively, not only by the front office but also on an independent basis by product control as part of the independent price verification (“IPV”) process. This process is especially important in turbulent markets.

A key process used by product control to ensure the accuracy of implied volatility, correlation and dividend marking by traders, is the IPV process whereby market prices or model inputs for derivatives are regularly and independently verified for accuracy. The objective of the IPV process is to reveal any error or bias in pricing, and it should result in the elimination of inaccurate marks. The three key points that were identified surrounding product control were:

1. Inappropriate communications and disclosures between product control and the front office regarding the IPV process.