Hedge Funds Weather A Data Management Perfect Storm

Oct 22 2014 | 12:28pm ET

By Alan McKenna
Global Head of Product Development
Equinoxe Alternative Investment Services

From a regulatory standpoint, nearly every development since the crisis has placed more demands on internal compliance departments and a firms’ data management capabilities. Compliance departments have seen headcounts beefed up accordingly, but data management systems and data governance policies have lagged behind.

These stresses are neatly encapsulated by the SEC’s enforcement of Rule 105, a rule designed to prevent firms manipulating the price of secondary stock offering by short-selling it ahead of time. Funds are not permitted to sell short a stock within five days of a public offering and then purchase the same shares. The rule has caught out numerous hedge funds, resulting in settlements totalling billions. One of the reasons it has been so prolifically enforced, is that the SEC does not have to prove any intention to manipulate the market: just that the illegitimate trades took place. With many secondary stock offerings now happening either overnight or even instantaneously, over-stretched compliance departments charged with monitoring for potential breaches of the law do not have the time to scrutinise their traders’ activities. Without the support of timely, accurate data, their job is impossible.

It is not just a tighter regulatory environment that is exposing data management weaknesses. The general speed, volume and complexity of trading activity has become too great for many firms’ infrastructure. At a very basic level, transaction data needs to be communicated with brokers in order to consummate trades. This is frequently done using out-dated mechanisms, such as emailed spreadsheets, or even faxes, and this dramatically widens the scope for human error. When you couple this with the increased volume of trades and the proliferation of different exchanges around the world, the potential for and trade settlement failures is multiplied. In most markets a failed trade means a fine from the regulator, a cost which is ultimately borne by the investors.

The consequences of poor data management are not the preserve, however, of fax-machine-wielding buy-side old timers. In August, Citigroup paid out $1.85 billion to settle with the US Financial Industry Regulatory Authority for consistent failures relating to manual pricing processes. The bank “lacked the necessary systems and supervision to ensure that it provided customers with the executions they deserved”, according to a statement from FINRA, which said the bank had provided clients with prices that were inferior to the best bid and offer in 14,800 instances.

In Europe, the Alternative Investment Fund Managers Directive has brought to bear a host of data-related challenges to hedge fund managers looking to market within the EU. The regulation, which technically came into effect over the summer, makes new demands of managers around valuation, risk management and stress testing, which in turn makes significant demands on firms’ data. Hundreds of data elements need to be reported, multiple data sources need to be managed, data needs to be enriched or transformed and interfaces need to be developed. A large swathe of managers in Europe are not yet fully compliant and, according to most estimates, the majority of U.S. managers have yet to comply. 

Aside from AIFMD, there is Solvency II, which is now due to be brought in late next year. Under the regime, if hedge funds cannot provide their investors – in this case insurance companies – with the highest level of transparency reporting (as required by the “look-through approach”), then they will become more expensive and less attractive to the investor. Between AIFMD and Solvency II, the need for more sophisticated data management techniques is becoming inescapable for funds wishing to raise capital in Europe. And while some managers located elsewhere in the world are making noises about ‘skipping’ Europe as a fundraising destination or, in the case of AIFMD, relying solely on reverse solicitation, this cannot been viewed as a sustainable long term business plan.

Regulators have certainly played their part in forcing managers to ‘up their game’ in terms of data management, but it is the institutional investors that are really driving change. We are seeing among our client base that investors have become significantly more demanding for transparency around risk and performance, beyond even what the regulators are demanding. Investors want an accurate and up-to-date view of what is generating returns, where the risks lie and whether mandates are being fulfilled or not. Of course, investor scrutiny extends further than just timely accurate views on exposures, also assessing the robustness of a firm’s infrastructure. Investors, particularly those making more influential allocations, are now fastidious in performing due diligence on their managers’ technology infrastructure, its efficiencies as well as its security.

Consequently, both regulators and investors are pushing managers to review and upgrade the way they approach data, but increasing sophistication and competition between managers is also playing its part. For both start-ups and established funds, the advent of "Big Data" and pressure to integrate other novel data sources, is creating complications regarding data governance policies (which surprisingly few managers have actually put in place).

The financial technology market is responding to these demands and the proliferation of cloud-based, hosted solutions has made outsourcing data management a relatively straightforward and cost-efficient process. Importantly, an outsourced solution allows managers to scale their data management capabilities in line with their AUM, paying only for the storage and software used. In today’s environment, with influential institutions like CalPERS thrusting hedge fund fees onto the front pages (yet again!), keeping costs to a minimum is a high priority.

The story does not end there, however; outsourced data management solutions introduce a layer of counterparty risk that needs to be accounted for and managed. Managers now exercise the same level of due diligence on their technology providers as do their investors on them (or if they don’t, then they absolutely should). The SEC issued a risk alert in April this year centring on cyber security within hedge funds. Managers are now hyper-aware of technology risk and have accordingly started testing their own systems’ integrity and taking greater interest in how external stewards of their data are protecting it. Checks on vendors stretch to a granular level: from whether USB ports on individual workstations are enabled, to password-reset protocol, to RSA token authentication, and so on.

The good news, therefore, is that in the face of a data management storm, the technology exists to allow even smaller funds to successfully comply with regulators’ and investors’ demands. The challenge for those funds, however, is in selecting partners that not only meet their technology needs, but do so in a way that keeps their data secure.

Alan McKenna is Global Head of Product Development at Equinoxe Alternative Investment Services. He has over 16 years of experience in the hedge fund industry.

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