Hedge Funds: Risk Reporting to Meet Demands of Regulators and Investors

by Eric Bernstein Oct 29, 2010

 Investors require in-depth risk reporting and lower fees whilst regulators are soon to introduce their own set of reporting requirements that hedge funds must comply with. In a Q&A, Sophis' Eric Bernstein explains how hedge funds improve the transparency in risk reports whilst managing operational costs efficiently in an ASP solution.

Q. How has risk reporting changed post-financial crisis? What are investors demanding?

As the regulatory outcome of the recently passed US legislation takes shape, hedge funds are becoming increasingly aware that they need to respond quickly to both the new regulation and as some argue more importantly, to investor demands. The post-financial crisis landscape has brought to light a number of changes on the buy-side, for hedge funds in particular. In addition to preparing for the registration requirement, managers are responding to regulatory pressure by fundamentally changing their methods for risk reporting. Funds that once operated under a closed-door policy are now re-thinking their reporting methods just to stay afloat. In an industry where it was once thought less is more, regulators and investors are teaming up to demand in-depth information they couldn’t even articulate before the 2008 financial crisis. To meet these requests, hedge funds have almost collectively started moving to independent reports that provide deep transparency levels comprised of information around risk sensitivity to market conditions, underlying prices, interest rates and credit spreads, to name a few. In step with this new wave of information-sharing, hedge funds are even beginning to explain terms such as Greeks to investors and regulators to better outline their exposure to counterparty, liquidity and systematic risk.

In the spirit of being prepared for the next downturn, making investors feel safe is paramount to keeping a fund alive. With risk reporting being an integral piece to that security, hedge funds have invested more in running stress tests, scenarios and VaR calculations independently. Prime brokers provide the positions and risk management platforms provide the independent valuation and risk figures, which are then used to report to investors and eventually regulators.

Q. How are hedge funds changing operations to create risk reports efficiently?

In order to tackle the need for comprehensive risk reports, hedge funds are addressing risk management procedures as a whole. If done in-house, this initiative can be time-consuming and expensive, so it is no surprise that many hedge funds have turned to outsourced solutions. At the forefront of this trend is the interest in an ASP service that can provide full risk reporting functionality including independent valuation, independent risk, P&L and operational risk reporting. In a multi-prime and multi-administrator world, large and small funds have taken a tremendous interest in ASP services for risk reporting that meet the demands of regulators and investors simultaneously while reducing cost.

Q. Why are hedge funds interested in ASP solutions now?

A combination of factors have led to increased interest in ASP solutions including:

• Increased number of hedge fund launches – As the economy starts to stabilize, new hedge funds are being introduced on a regular basis. Their understanding of the post crisis landscape gives them an opportunity to form processes at their launch date that will meet and exceed investor and regulator demands. One of the easiest ways for hedge funds to enter the market with their feet on the ground is with a turnkey risk reporting solution through an ASP model. Costs are often lower, implementation time frames can range anywhere from a few weeks to a few months and most importantly potential investors are attracted to this type of transparency, bringing in more capital.

• Using independent reports is important for hedge funds because it allows them to rely on the expertise of an outside source for their data. Most hedge funds don’t have the means or the bodies to do all the necessary data scrubbing to ensure that what is reported is clean.

• ASP solutions are attractive because multi-prime brokers feed into them directly, allowing the platform to process positions, transactions and market data directly.

• ASP solutions can not only run standard reports, but have the ability to create and run customizable scenarios, this includes VaR, performance attribution, stress tests, etc. These reports can be accessed in T+1 and are highly configurable in duration leading to meaningful, flexible data on the fly.

• Cost reduction is another benefit. Outsourcing to an ASP cuts down on the expense of building and running a legacy system that is able to keep up with the frequent demands of investors and regulators. Staffing personnel to run these efforts will also add to the bill, all which can be alleviated through implementation of an ASP solution.

Q. What should hedge funds expect from the regulators in terms of new risk reporting requirements? What will regulators require and how will firms comply with these demands?

With the combined demands of regulators and investors, it would make sense that risk reporting be standardized to maximize efficiency. Developing a protocol for reporting that resonates with regulators and investors will help meet the industry’s demands for a more transparent buy-side. While it is still yet to be established, discussions around risk communication will be a big part of 2011. To prevent standing still or even falling behind, ASP solutions like iSophis, offer both fpml and xml format options, so hedge funds can be prepared for whatever standards lie ahead.

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Eric Bernstein is Chief Operating Officer of North America for Sophis, Inc. Eric is responsible for all activity in North America including Sales, Support, and Professional Services.

Prior to joining Sophis, Eric held various positions at Linedata Services including Senior Vice President in charge of North American Sales, Senior Vice President in charge of Global Product Management, and Head of Relationship Management. Eric also held positions at PaineWebber, Inc as Head Equity Trader for PaineWebber Specialists Inc., and in Capital Markets Equity Trading. Eric held a position at Melvin Specialists, Inc. as a Market Maker and Equity Trader as well. Eric holds a B.A. in Economics from the State University of New York.