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I have a question regarding the marking consistency (from an accounting point of view) between bespoke structured trades and the listed instruments that may be used for their hedging purpose:

  • Since there is no market for the structured trade, these are mainly marked through consensus services (Totem, ..) via theoretical prices
  • Hedging instruments however may be listed, in which case they will end up having market prices

Now, ignoring all side effects that may cause the listed market price to be irrelevant, there will more than likely be some inconsistency between the trade theoretical price (if marked to the consensus) and the hedge instrument price (if marked to market), yielding a PnL which should not really occur.

In the end, one would have to chose either to use theoretical prices (via consensus) for the hedge in order to keep the book consistency or to correctly mark-to-market these and have to deal with the resulting Structured-Hedge PnL: Is there any other cleaner way to tackle this issue ?

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I'll try to give some views on this, I hope it helps bringing some closure to your question.

You seem to relate consensus to "theoretical prices". I think this is a bit misleading. I view consensus as nothing more than the average view across the street for market factors, e.g. the correlation between the Korean KOSPI and the Spanish IBEX, the volatility of Kazakh inflation, etc. So it is really an aggregation of views (i.e. the view of JP's trading desk, Citi's, etc.) for a specific market factor. When push comes to shove, what matters is the actual price at which somebody does trade. Consensus for certain market factors might be meaningless because there hasn't been a single transaction in weeks or months.

I don't really see the discrepancy between the consensus and the desk's mark as "proper" PnL. From experience, there are usually 2 parameters to take into account when assessing discrepancies between the desk and Finance:

  • The gap between the desk's PnL and the PnL implied by the consensus;
  • The strength of the consensus.

You use the words "consistency", "should not really", "correctly" or "cleaner". Generally speaking, when there are significant discrepancies (what is sometimes termed "variances") between Trading and Finance, that means the market factor itself is thinly traded, thus the strength of the consensus (the evidence of mismarking) is weak. For example, the consensus for KOSPI-IBEX correlation is 70% but your desk is marking at 20%; you go to them and tell them "you're way off the street, you need to remark", but then they say "there hasn't been a single transaction in months, that consensus is not reliable".

The bottom line is, quite often when there are significant variances, Finance has not strong evidence to mandate Trading to re-mark, unless maybe e.g. the gap is really wide, or it has been persistent, or the desk has not re-marked market factors for a long time, etc. It's a grey zone in which nobody really has much evidence to force things one way or another, and thus the implied PnL difference is rather "abstract".

From an accounting perspective, I am not an expert but how can you deal with changes in PnL due to remarking? Somehow you need to balance things out, either by directly reassessing the PnL or recording/releasing some balance sheet reserve. Different choices might affect the balance sheet and income statement in different ways, but it will ultimately find its way towards the bottom line.

Edit: remarking or taking a reserve will both affect the bottom line as well as the desk's PnL, however remarking consists on updating the parameter values and hence has an impact on risk metrics such as VaR.

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  • $\begingroup$ Thanks for your insightful reply: my question was a bit unclear I think but it mainly concerned the case you mentioned of a wide discrepancy between Finance and the Desk mark, for an instrument that is actually actively traded in the exchange. My view is that, from an accounting perspective, this discrepancy should somehow be reflected in the banks’ balance sheet. $\endgroup$ – Ouadia Oct 8 '20 at 8:11
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    $\begingroup$ @Ouadia If the instrument is widely traded, with abundant data, then I understand Finance will probably have enough evidence to mandate Trading to remark the position (instead of taking a reserve), so this probably will be directly reflected in the balance sheet through the PnL of the trading desk. However it is unlikely that for a liquid instrument, there will be a wide discrepancy between Trading and Finance. $\endgroup$ – Daneel Olivaw Oct 8 '20 at 8:18
  • $\begingroup$ @Ouadia let me correct my previous comment. I just asked a colleague about this. It does not matter whether the solution is to remark or take a reserve, both solutions will impact the PnL of the desk. However, if you remark, you're actually changing the value of market parameters. This will have a direct impact on sensitivities and therefore on risk metrics such as Value-at-Risk. Preferred way is to ask for a remark (so that it is reflected in risk), but there is a certain tolerance before asking for remarking/reserve. $\endgroup$ – Daneel Olivaw Oct 8 '20 at 8:46

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