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Buy-side institutions are feeling the strain of new regulatory compliance requirements and increased demands from investors for transparency. In a Q&A, Misys' Jean-Baptiste Gaudemet explains how hedge funds and asset managers are improving risk mitigation, collateral management and reporting processes to satisfy the expectations of both regulators and clients.
Q. How are buy-side firms improving trading processes to meet new compliance requirements including AIFM, UCITS and Dodd-Frank?
Generally, investment management companies are looking to streamline the compliance functions within their operational processes. From a post-trade perspective, the biggest challenge for the buy-side is the Dodd-Frank Wall Street Reform and Consumer Protection Act and European Market Infrastructure Regulation (EMIR) because these new regulations require firms to connect to new market infrastructure including clearing houses and swap execution facilities (SEFs) via their prime brokers. Furthermore, firms need to consider how they will migrate to this new infrastructure and integrate with existing operational processes. The ease in which this is done depends greatly on the existing technology used by the firm.
The good news is that for most vanilla products, the reforms will increase the standardization of the contracts which will lead to decreased complexity and costs. This evolution will be a good opportunity for firms to establish and improve straight-through-processing (STP) across their derivative operations. If we try to assess the long term impact for the industry, it appears that implementing full STP across the new central clearing platforms will be a key differentiator among market participants. For example, investment companies that continue to rely significantly on manual tasks will have a competitive disadvantage compared to those that have deployed efficient and streamlined derivative operations. This will ultimately limit growth and the ability to launch innovative products.
In Europe, reluctance from investors towards risk and the rising appetite for transparent and reliable investment management has fostered a move towards on-shore investments like the UCITS funds. The requirement to restore confidence and to attract more capital or to gain new clients such as institutional investors increasingly led alternative investment managers to streamline compliance monitoring throughout their investment process. Moreover, the due diligence of investors has introduced a major focus on pre-trade operational controls to ensure compliance with regulation and investment guidelines. Investment management technology efficiently delivered solutions by streamlining a wider range of control (concentration, VaR, liquidity limits) for the pre-trade processing.
Q. Is real-time risk management important for buy-side firms? Is this something they are investing in?
Buy-side firms are looking to real-time risk management to get a better overview of their portfolio exposure, which supports the investment decision process and portfolio management generally. The latest generation of technology enables firms to leverage real-time sensitivities, P&L explanation and VaR for highly sophisticated strategies to enhance front-office risk management. This is something that was simply not available before and it opens the way to unprecedented control over complex cross-asset portfolios. The benefits of more accurate risk controls and responsiveness are critical to address extreme market volatility. Portfolio managers are increasingly looking to use real-time risk reports as a risk tool and they want the reports to contain an explanation of Profit and Loss so they can have a truly complete understanding of their positions and their performance. Also, these reports, and the end of day reports in particular, can be used to support regulatory compliance requirements in addition to the investment process.
Q. How important is the ability to run customized risk scenarios to obtain a view of how portfolios would perform in different market conditions for fund managers today?
With stress testing, asset managers and hedge funds are gradually catching up with the investment banks in market risk management and are expanding their ability to stress test the market using with various risk scenarios. Not only is it critical for investment companies to historically measure and internally define stresses but they are also required to be responsive to markets evolutions. Depending on the different levels of risk that may arise, investment companies need an easy and flexible way to define stress tests on the fly.
Computing newly identified risks into market stress tests and monitoring their impact on portfolios provide investment companies with the visibility needed to survive during a crisis. Furthermore, to protect their firm from excessive concentration, investment managers increasingly monitor ‘total plan’ impact on the global managed assets and not only on a fund by fund basis. It is crucial for C-level executives to have access to holistic and responsive risk reporting during a crisis. For instance, if a bank or government debt becomes susceptible to risk as a direct result of a major catastrophe, there is an immediate requirement to answer questions like "how might fund performance be impacted by such a scenario?” Or “what is the investment company’s total exposure to such a downturn?"
Q. How are hedge funds changing the way they manage their collateral? What is their motivation to make improvements?
Historically, hedge funds have relied on brokers for margin calculations and collateral calls for trades but this process is not transparent and firms had to have a high level of liquidity to handle margin calls in different market situations. Now, many buy-side firms are looking to improve in-house collateral management capabilities to gain more control over this process and their liquidity, especially in times of high market volatility.
Furthermore, with the new regulation, as well as increased capital and margin requirements for centrally cleared trades, firms are looking to manage collateral more efficiently. Technology can help investment companies to improve this problematic area of the business by providing much better visibility across the liquidity risk of funding. Better forecasting will simplify operational maintenance of margining and obviously decrease uncertainty on potential liquidity requirements.
Q. How are firms improving transaction cost analysis reports to provide investors with the increased transparency they are demanding today?
There is demand for transparency on all transaction-related data, including cost and the market conditions during execution, provided in the transaction cost analysis reports sent to investors and potentially to regulators.
For instance, with the growing trend towards increased electronic trading, buy-side firms now have access to a full audit trail of their orders and can show execution and the performance based on their best execution policy. This will be particularly interesting to investors who want assurances from fund managers that there are protocols in place to ensure their assets are being invested responsibly and intelligently. Investment companies can demonstrate this using reporting and transaction cost analysis, which will invariably lead to investors being more trusting and open as a direct result of increased transparency and information available to them.
Q. Are buy-side firms looking to reduce operational risk?
Yes, to reduce operational risks firms are aiming to replace the use of excel spreadsheets with automated technology. Be it at the trading decision or post-trade level, investment companies do not want to rely on ad-hoc manual and excel based tasks any more, which restrict growth and often lead to operational incidents. There has been a particular focus by investment companies to streamline most of the investment process and improve security by using automated controls.
For instance, at pre-trade level, periodic tasks like hedging or overlay management have been integrated with dedicated tools to create a seamless and transparent process. Furthermore, reducing the amount of operational processing from portfolio management tasks ensures firms to maintain robust and sustainable workflows over time. Pre-trade constraint management and audit of investment decisions are also providing answers to decrease pre-trade operational risk. At the post-trade level, trade workflows and STP are always combined with more secured matching and reconciliation capacities. Therefore, for major investment firms, OTC trade matching in addition to cash and asset reconciliation with custodians is completed with full Net Asset Value (NAV) reconciliation with administrators. By reconciling and challenging their counterparties, firms intend to tackle and preempt potential operational issues and ensure portfolio management is performed with maximum visibility of the portfolio.
Q. What is the benefit in improving investment management processes for long-term growth? What is the silver lining of these regulatory requirements and strategic investment in operational processes?
Having efficient risk and operations management will enable an investment management company to comply with regulatory requirements and to decrease costs but also attract new business from risk reluctant and information-hungry investors.
The industry has changed dramatically over the past decade where historically investors were less interested in how funds were run and only considered historical performance as the necessary selection criteria for their investment. Now when it comes to choosing a fund, investors have a lot more information about the fund’s rating, the systems that they use and the markets and asset classes they invest in. So, a buy-side institution that can demonstrate due diligence with regards to the way their fund is run, will have a clear competitive advantage in attracting new investors now and in the long run.
Jean-Baptiste Gaudemet is head of Misys Sophis product management for RISQUE, VALUE and iSophis. He is responsible for the strategic product roadmap, as well as client driven evolutions globally. Jean-Baptiste has been working at Sophis for 7 years and has previously held positions within professional services, in addition to being a pre-sales manager for investment banks in the UK.