Hedge Funds: Proactive Operational Risk, Finally

These glitches aren’t new for hedge fund managers. What is new is that they are turning to management and technology consultants for help.  As regulators, such as  the US Securities and Exchange Commission, look under the hood during exams and investors become a lot savvier, mitigating operational risk is starting to become as important as portfolio risk. Hedge fund managers have to prove to securities watchdogs and investors their middle and back-office operations are up to snuff.  Even the best investment results won’t last if post-trade mistakes grow. Regulatory fines and a potential exodus of investors can easily occur.

Post-trade operations managers at about  two dozen hedge fund management firms contacted by FinOps Report over the past week say they are spending about forty percent of their time evaluating the efficiencies of their middle and back office functions. They need to uncover whether they have the right mix of automation and manual labor and how they can reduce manual intervention.

Included in the qualitative and quantitative analysis is an evaluation of their prime brokers and fund administrators. “Hedge fund fmanagers are asking more questions about  operational controls such as cash and securities transfers, reconciliations, trade bookings and handling of aged settlement fails,”  says Christopher Caruso, president of Pangaea Business Solutions, a New Jersey-based advisory firm focused on hedge fund manager due diligence reviews of prime brokers.

Prime brokers are being judged on a combination of cost and operational effectiveness. “Hedge fund managers will expect their prime brokers to have the operational sophistication related to the fund managers’ investment mix,” says Caruso. “A more complex strategy based on OTC derivatives and fixed-income instruments or international securities will require greater operational capabilities than a simpler long-short strategy.”

Hedge fund managers are finding that the right solution depends on the right combination of workflow management, governance and technology. Strictly relying on one’s fund administrator or prime broker to fix any middle and back office woes isn’t the best decision because fund managers remain on the legal and financial hook for any operational errors. There is also only so much service providers either can or are even willing to do based on what they earn. New Bridge Consulting Group, a New York-based management consultancy, says that its services are in high demand from prime brokers who want to focus their time on supporting their clients’ trading and funding needs rather than addressing their  middle and back office woes. Prime brokers can hire New Bridge to do that work for them. Hedge fund managers can use up a designated amount of time pre-paid by their prime brokers and pay for any extra they need.

There are no official figures on what operational mistakes cost, but some hedge fund operations managers say they can amount to a few hundred dollars to multi-thousands or even millions to correct depending on the financial instrument involved, type of error and how long it takes to resolve. Trades may even have to be unwound.  “You can’t correct what you can’t measure,” says Edward Watson, a partner at New Bridge Consulting. “If you can’t quantify your operational risk, chances are you are in worse shape than you think.” The reason: the hedge fund manager will likely be spending far more money correcting problems than in preventing them in the first place.

Anything can and will go wrong. When reference data or settlement instructions involving a trade aren’t correct, or borrowing becomes a problem, count on the trade failing to settle on time. “Just one failed settlement can wipe out some or all of the profit on the trade,” says Watson. Short sales can also become problematic during times of low liquidity and high borrowing demand.

 “Some hedge fund managers won’t want to start trading any new products unless they go through a workflow chart outlining the entire process from the time the trade is executed to the time it is settled,” says Watson. What happens in-between is what counts. He recommends that hedge fund managers measure their operational risk along the entire trade lifecycle from inception to settlement and posting to the general ledger. “To the extent a trade doesn’t follow straight through processing an operational break can be captured and corrected in real time,” says Watson. “A root cause analysis can be performed to understand and remediate the cause of the process breakdown.” Ideally, any lessons learned can be applied to prevent future breakdowns.

Failing to settle a trade on time is bad enough but what happens when an asset is misvalued can be even worse. Depending on the hedge fund’s investment strategy and the size of the holding relative to the value of the entire book of business, one pricing mistake can lead to a miscalculation of a portfolio and its net asset value. That’s bad news for investors wanting to redeem their holdings. The chance of a mistake increases exponentially with the liquidity of the financial holding involved because there is no publicly agreed upon price.

Relying solely on fund administrators and prime brokers isn’t the answer if they don’t have solid valuation procedures for non-exchange traded securities. Hedge fund managers are also the ones on the hook to regulators and investors so they must turn to internal pricing models, methodologies and third-party data sources.

The savviest hedge fund managers are forming valuation committees and relying on independent valuation firms for help. “Every hedge fund manager should have a written valuation policy and a valuation committee that is responsible for defining the process, the independent pricing sources and all procedures used for pricing,” says Frank Caccio, chief executive of FJC Partners, a Freehold, New Jersey firm which operates OpsCheck, a web-based workflow management and compliance platform.

The valuation should consist of a wide-range of trading desk, middle-office and third-party service providers. The more illiquid securities are the more involvement and time commitment will be required. “Ultimately, senior management, preferably the chief financial officer, should sign off on any NAV calculation,” says Caccio.

Surprisingly, not every task at a hedge fund management shop can be done with the touch of a button. Hedge fund managers will typically want to automate their daily reconciliation of cash and positions with fund administrators and prime brokers to catch unconfirmed or duplicative trades, oversized or undersized positions and duplicate or missing cash transactions.

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esn’t do the manual clean up, the error will continue and the costs of fixing it will only magnify. Uncorrected errors can ultimately cause incorrect portfolio valuations, wrong profit and loss statements, and wrong margin calculations. Automated workflow management tools can go a long way to ensuring mistakes don’t become life threatening. OpsCheck will keep track of which employee should finish which task and will alert compliance managers and other supervisors when a task remains uncompleted.

If fixing one’s house is hard enough, imagine having to ensure everyone else you do business with is also just as clean. Enter the brave new world of third-party vendor management. It’s fraught with heartache if not done properly. What happens if a fund administrator has a technical glich and misvalues a portfolio or can’t value a portfolio at all? Chances are that the hedge fund manager might be out of luck if it can’d do the work on its own or doesn’t have a backup plan. Since hedge fund managers price on a monthly rather than daily basis, they might have enough time to scramble and do manual calculations.

But some hedge fund managers don’t want to take any chances. Relying on shadow accounting firms to parallel the same activities conducted by fund administrators is becoming an attractive option. The dedicated service providers can do a lot more than just calculate NAV in a pinch. The additional expense, borne by investors, is well worth the cost, according to one shadow accounting provider Viteos Fund  Services. Why? “The extra work can also be used to create a complete investment book of record for all positions and holdings which can help fund management teams make informed decisions on their middle office,” explains Shankar Iyer, chief executive of Viteos Fund Services, headquartered in  Somerset, New Jersey. “Where is my cash, what are my counterparties charging me, and which trader is producing the best return on investment, are just three of the critical questions that can be quickly answered.”

While all of the information for an IBOR could theoretically be produced by a fund administrator it is more likely that a specialist shadow accounting firm can do the work a lot faster. Fund administrators are also geared

to producing accounting books of record (ABOR) suited for back-office rather than middle-office needs.

Although in-house fund management accounting units could also handle shadow accounting, relying on third parties also ensures no collusion or fraud occurs, says Iyer. That means no inflated valuations by rogue managers, the appearance of “phantom assets” on books and records and even inflated cash statements that might not be caught even by fund administrators.

A late NAV is bad enough news for a hedge fund manager but a cybersecurity breach at a third-party service provider such as a fund administrator, custodian, prime broker or third-party data analytics provider can be catastrophic. Sensitive client data can be lost and so can plenty of money as shown by the 2016 cyber-breach Tillage Commodities Fund alleges was caused by its fund administrator SS&C Technologies. Tillage claims that SS&C was duped by China-based hackers into releasing US$6 million of funds through poorly written emails. The legal suit, debated in New York courts, has yet to be resolved.

Buying cybersecurity insurance isn’t a panacea. Policies don’t always cover activities or exposure from third parties. Instead, they are focused on the breaches of the hedge fund itself. “Fund managers need to ensure their third-party service providers undergo the same rigorous cybersecurity risk procedures as they do,” says Joanna Fields, managing principle of New York-based Aplomb Strategies, a regulatory compliance and financial technology consultancy. “Due diligence questionnaires can and should be used when questioning prime brokers and other service providers who should be willing to disclose their policies.”

Fields offers the following examples of potential questions hedge fund managers should ask: does your business recovery or business continuity plan include the business requirements for hedge funds; do you have data integrity controls in place to identify breaches, missing or corrupted data files; and are your emails securely sent.

Fred Kneip, chief executive of Denver, Colorado-headquartered CyberGRX offers two more: are you patching your software and training employees in phishing. “It comes down to basic cybersecurity hygiene,” he says.  As is the case with other financial firms, hedge fund managers need to take a risk-based approach to cybersecurity risk management and spend the most time evaluating service providers which pose the highest financial risk. CyberGRX lets hedge fund managers and other financial firms cut down on time and cost of accessing data on the cybersecurity preparedness of hundreds of firms, including fund administrators and prime brokers. The firm charges users varied subscription fees to find  information on the readiness of third-party firms based on the level of validation they wish. Tier One firms are the ones whose responses on cybersecurity risk have been validated through CyberGRX’s partnership with Deloitte & Touche while Tier Two firms are those whose responses have been validated by CyberGRX on an algorithmic basis. Tier-three firms are the ones whose responses are self-certified.

Kneip says that while CyberGRX was initially embraced by mega banks and broker-dealers, hedge fund managers are becoming the fastest growing segment of his firm’s client base.  The largest ones are quickly catching up to the cybersecurity maturity of their bank and brokerage peers while smaller ones are also realizing that even using the basic Tier-three service is better than doing nothing.

Relying on technology and due diligence aren’t the only ways to reduce operational risk. Because operational risk overlaps with conduct risk, a clear delineation of responsibilities is also imperative. “An essential element to operational safeguards is to establish a clear separation between the investment team and the operations functions,” says Caccio. “Reconciliations, NAV calculations and pricing should be determined by individuals not involved in the investment decisions.”

Hedge fund management shops also shouldn’t be too cozy with their service providers. The selection process needs to be clearly vetted so there is no conflict of interest, says Caccio. Case in point: fund managers don’t want to be doing trade execution g or post-trade activities with a firm owned by the family of one of their employees. Likewise, a hedge fund manager can’t afford to switch critical service providers, such as auditors, administrators and prime brokers too quickly. Investors will wonder if something fishy is up.

Ultimately, operational risk management will require an analysis of product, process and people. Hedge fund managers know that mistakes can result in short-term financial loss and even longer term reputational loss– a regulatory fines and investor redemptions. An ounce of prevention, or even better a pound,  can increase performance results, keep regulators at bay, and help retain, if not add client monies.