US Registered Funds: Say Hello to Derivatives Risk Managers

Must have knowledge of derivative products, risk management, compliance procedures, technology implementation and project management. An MBA or graduate degree in financial engineering is required. A certified financial analyst designation is preferred.

Those are the likely employment requirements for the derivatives risk manager that many US registered investment funds will have to hire if the Securities and Exchange Commission has its way. Although the job title appears only briefly in newly proposed rules by the SEC for registered investment funds to manage their use of derivative contracts, the mere mention is generating plenty of debate. Operations managers tell FinOps Report the hiring the right person won’t be easy, because the broad expertise in setting up and overseeing a specific derivatives risk management program may be hard to find.

“The SEC is trying to strike a balance between the desire to manage the risk of derivatives and the desire of fund managers to meet investor demands for innovative investment strategies,” explains Jay Baris, director of the investment management practice at Morrison & Foerster in New York. “Funds that use derivatives will face new compliance challenges in establishing required derivative risk policies and procedures administered by a derivatives risk manager.”

The regulatory agency has considered requiring US registered investment funds to curb their use of derivatives since 2009, but the rising popularity of liquid alternative funds and investment strategies involving complex derivatives has prompted to take prescriptive action. Until now, registered investment funds have been told to control their leverage, but offered little clarity on exactly what that means. Section 18 of the Investment Company Act of 1940 never mentioned derivatives when it said that registered investment funds are prohibited from “issuing senior securities” or other evidence of indebtedness. Likewise, in the 1979 release of its Guidance 1066 about the 1940 Act, the SEC doesn’t explicitly cite derivatives when it reassured registered investment funds that they would not be violating Section 18 provided they segregated sufficient liquid assets to cover potential financial obligations.

The SEC’s subsequent no-action letters and guidance tried to close that loophole, but they were apparently so muddled and contradictory that some registered funds took on more leverage than the SEC wanted, say legal experts. By the SEC’s own calculations, about four percent of registered investment funds have an exposure to derivatives that exceeds 150 percent of their net assets. The SEC wants any new rules to eliminate any misunderstandings and be codified as a new Rule 18 f-4 of the 1940 Act. Industry feedback is due by March 28.

Only registered investment funds which invest in “more than a limited number” of derivative contracts or rely on “complex” contracts will need to tap a dedicated derivatives risk manager to administer a specific derivatives risk management program. The SEC defines “more than a limited number” to mean derivatives contracts whose aggregate notional value comes to more than 50 percent of the net assets of the fund.

The regulatory agency doesn’t provide any examples of complex derivatives, but in its technical explanation says that such contracts reflect one of two scenarios on how payable amounts are calculated. One is where the amount payable depends on the value of the underlying reference asset at multiple points in time during the term of the transaction. Asian and barrier options would fall under this category, say swap experts. The second definition of complex derivatives would include payments which represent a “nonlinear function” of the value of the underlying reference asset. Such is the case with variance swaps. However, there is one exception: the non-linear payoff from a single strike option such as a call option.

Better Safe Than Sorry

Risk management experts recommend that fund management firms consider future rather than current strategies. They may not currently cross the 50 percent threshold or trade in complex derivatives, but could do so in the future. Setting up a program under the watchful eye of a dedicated derivatives risk manager now rather than later would be easier than scrambling to do so before a regulatory exam or, even worse, before leverage spirals well beyond initial expectations.

In its request for comment on the proposed rules, the SEC says that a derivatives risk manager must work independently from their firms’ portfolio management departments to ensure no conflict of interest. That leaves fund management firms with one of two options — either hire a professional from outside its walls or designate a person from within. Either way, there aren’t too many people qualified — or even willing — to do the job. “It’s a very specific function with hard-to-find requirements. Because the SEC has created a dedicated title, fund management firms will need to be conscious of the potential liability involved with the role,” says one operations manager at a US East Coast mutual fund management firm. “At the very least that executive’s job will be on the line if the firm makes a mistake. In a worst case scenario, he or she will be have to come up with explanations and corrective action to satisfy SEC examiners eager to slap regulatory fines.”

Although there is no shortage of risk management specialists at sell-side firms, say executive search experts, it is unclear whether they would want to jump ship for a buy-side firm that will likely pay a lot less. To fill the spot in-house, fund management firms may opt for either the chief compliance officer or chief risk officer. That is, if they have a chief risk officer. Most mutual fund complexes don’t have such a dedicated risk officer or a formal derivatives risk management program, so they may be tempted to assign the responsibilities to the chief compliance officer. The rationale: he or she knows how to keep the firm on the straight and narrow.

Not really a good idea, warn some experts. Samuel Won, managing director of risk management advisory firm Global Risk Management Advisors in New York, says that fund management firms need to consider all of the challenges involved, if the SEC’s proposed rules become effective. “The derivatives risk manager must not only be responsible for designing a derivatives risk management program and monitoring its testing, but also ensuring that it works on a continual basis,” he says. Such work requires not only a solid knowledge of technology, but also a solid understanding of derivatives products and experience performing the risk calculations, which most compliance directors simply don’t have, Won believes.

The best technology must be coupled with content knowledge, agrees Ashu Sharma, senior manager with IMP Consulting, a Boston-based consultancy specializing in testing compliance and post-trade technology at investment management firms. “Granted, the SEC’s proposed requirements are based heavily on the ability of technology to monitor the amount of trading a firm does in derivatives and make the necessary calculations so that it does not exceed certain thresholds,” he says. “However, the derivatives risk manager will still need to have experience with complex risk metrics.”

Who Knows Best

As if number crunching and monitoring weren’t hard enough, derivatives risk managers will also be adept at educating their boards of directors, which must approve their work. “While it would not be practical for directors to understand the mathematical formulas behind each complex derivative contract, they should have a level of knowledge that is sufficient to allow them to evaluate the reports the derivatives risk manager provides,” says Baris. Derivatives risk managers must help boards make sense of what they read by clearly explaining the methodology used for calculations, as well as the technology and oversight implemented.

Concerned about their own potential liability, board members are likely to be asking for plenty of reassurance that the fund won’t breach regulatory requirements. Given that sophisticated knowledge and experience are critical to fulfilling their legal obligations, fund boards may seek outside help. Won says that his firm offers a complete one-stop outsourced solution to comply with the SEC’s proposed derivatives rules, including producing the required risk calculations, establishing a proper derivatives risk management program, independently monitoring risk levels and assuming the role of derivatives risk manager.

Among the multitude of responsibilities facing a dedicated derivatives risk manager is ensuring his or her firm has calculated its exposure correctly. The SEC is allowing one of two ways — a portfolio risk management or risk-based test. The portfolio risk management methodology is easier to use, but more restrictive. The calculation would be based on the notional amount of the fund’s derivative contracts and “financial commitment” transactions such as short sales and reverse repurchase agreements; securities lending deals are exempt. The fund would ultimately have to limit its commitments to aggregate exposure of less than 150 percent of the firm’s net assets.

Alternatively, a fund could rely on the “risk-based approach” which would give it more investment leeway. It could enter into derivative contracts up to 300 percent of the value of the firm’s net assets as long as it shows that investing in derivatives results in less market risk than not doing so. The exposure is calculated using the fund’s aggregate notional amount of derivative transactions and its obligations under “financial commitment” transactions.

“The [VAR] methodology sounds ideal, but it could typically only be used if the mutual fund relied on derivatives for hedging purposes,” says Matthew Bromberg, a partner with the law firm of Reed Smith in New York. “That strategy is likely be the case for most mutual funds, but liquid alternative funds — or those which rely on more opportunistic hedge-fund like investment strategies –would have to make their calculations using the more conservative portfolio risk management approach.”

In managing their derivatives exposure, registered investment funds would also have to segregate or allocate a sufficient amount of liquid assets to take into account the potential losses. The value of those assets must not only be calculated based on the costs of exiting the derivative transactions at the time they were terminated or before, but also with additional consideration of exiting under “stressed” market conditions. “Although funds have historically allocated liquid assets to account for potential financial loss, they might not have included a cushion in their calculations,” says Bromberg.

Partnering Technology and Process

Just how can the fund management firm ensure that it doesn’t exceed the allowed percentages under either the portfolio-based exposure or the risk-based exposure metrics? Ideally, says Sharma, the firm will integrate its order management system with a risk calculation engine to calculate how each derivatives contract changes either the portfolio exposure figure or the risk-metrics figure. The accuracy of the calculation depends on using the correct notional amount for each derivative transaction and the SEC has come up with different approaches for calculating those values depending on the type of contract.

The risk calculation engine must also ensure that it has the right net value of the fund derived from an OMS or a back-office system. The calculation engine would flag whether an exposure limit has been breached. If so, a compliance engine should trigger an alert. “A risk calculation engine, communicating in real-time with an order management system and a compliance system can ensure that the proposed rules are met,” says Sharma. “Even if the firm has a platform meeting the criteria of a single investment book of record, a compliance engine would still be needed.”

The fund management firm’s derivatives risk management program must be tightly linked with the firm’s liquidity risk management program, as also proposed by the SEC. A fund should take into account the liquidity profile of all of its holdings in stressed and unstressed markets.

Even if the right applications are implemented, they will be ineffective if the correct procedures aren’t in place, explains Won. “Technology accounts for only a small segment of the overall solution that is needed,” says Won. “Risk and compliance professionals should on a regular basis be monitoring reports generated. They must do so even more vigorously when the firm is close to reaching the 150 percent or 300 percent limits on exposure so that the trading desk or portfolio manager can take the necessary steps to ensure the thresholds aren’t breached.

Won’s words of advice for fund management shops and their derivative risk managers: make sure the derivatives risk management program clearly defines the roles and responsibilities for who does what, when and how, ensure that the technology and necessary controls are in place for producing the required risk calculations and reporting them, verify that the proper procedures are implemented for monitoring risk limits, and last but not least establish an escalation policy to take effect if the limits are inadvertently breached.

There is no easy way to meet the SEC’s proposed rules. The regulatory agency suggests that certain managed futures funds and leveraged exchange traded funds will either want to change their investment strategies or deregister with the SEC. While adapting strategies might be feasible, deregistering is not, says Won. There is simply too much money at stake from institutional investors who may balk at investing in an unregistered fund. Fund management shops may just have to grin, bear it, and adapt.