The new MiFID II regulations are making many more reporting demands of hedge funds, not least of which is how to embed the new regulatory reporting standards within their operational processes. It is a lot more difficult than it looks on paper. Below we look at some of the issues funds need to consider, when to ask for outside help, and what sort of internal technological solutions are on offer.
Proper management of data sits at the core of any strategy designed to help your firm to report effectively under this new regime. The MiFID II Directive, for example, covers all financial instruments traded anywhere in the European Union, including via any EU broker. Everybody that provides data as part of a trading cycle that touches on the EU is affected by the directive. For US brokers, providing a venue to EU trading counterparties means that they too fall within scope.
The important first step is to get past the belief that such reporting can be managed manually. It can’t and it won’t be over the long term. Human errors will occur and a firm will find itself in technical breach of regulations. The automation tools are already available to make these processes something that hums along in the background, to be referred to only when you need to. Without this realisation by hedge funds, the regulatory risk of a breach will be a constant risk, and it will be a potent one.
On top of this, consider the proposition of traders manually calculating their position limits. How is this going to work in practice?
Wading through the new regulations is a huge task. This is why we advise clients to retain a regulatory expert in the first instance who can advise on a firm’s exposure and help it to develop a requirements document.
Not all hedge funds will be large enough to have access to internal compliance resources, but it is important that a compliance specialist is able to take a close look at what the investment business is doing, and to develop an understanding of who all the parties are that are likely to fall into scope.
There will be many questions that need to be answered at this part of the process: who are your buyers and sellers, who is who and who is doing what, and most importantly who is in scope? What should you be reporting and when?
This is also a good opportunity to develop a clear picture of your balance sheet. This is usually a straightforward process but you will need to have an understanding of which instruments on that balance sheet are covered by MiFID reporting requirements. A compliance advisor will be able to help to map this out.
Using an Approved Reporting Mechanism (ARM) like Bloomberg or DTCC can be very useful at this point in your journey, as they can act as an intermediary between the fund and the regulator. They already know what needs to be in the reports and how they should be presented. Avoid the pain of doing this yourself if you can. An ARM is specifically tasked with ensuring that the reports submitted to it are correct and will reject them if they are not.
Let’s not underestimate the complexity of the reporting required by ARMs. End of day reporting is no longer adequate under this new regime. It has to be as real time as possible. We work with funds to help them to report on a post-trade basis and within the defined exchange base limits. This helps to prevent intra-day breaches from occurring.
We advise hedge funds to have pre-trade checks in place that do not require their traders to go through a time consuming pre-trade compliance process. Under the new MiFID directive there are a range of checks that now may apply to your firm, and it may be your trading desk will need to manage a combination of both pre and post trade checks.
The biggest challenge you will face when managing your reporting is how to deal with your data. Hedge funds, regardless of strategy, typically find they need to integrate their data from numerous sources. This will require an effective data mapping exercise which will need to be updated periodically.
Every exchange you trade on will have its own product codes. These need to be split up and managed so that those instruments that are in-scope can be identified. Part of the problem here stems from the fact that contracts must be bucketed in the spot month versus all months or other months depending on the exchange limit.
Just taking futures contracts as an example, while a contract for every month might be in the fund’s data system, a fund manager needs to be able to recognise when futures contracts fall within scope on a dynamic basis. Ultimately this is best resolved by tracking every contract month in your system. This can be achieved by working with an appropriate data provider or technology partner who has access to this data.
Another issue arises from the fact that every exchange reports its data differently – there is no single, widely accepted template that is used by all exchanges. In addition, you will need guidance on issues like position expiry and delivery limits, the last five trading dates prior to expiry, as well as the exchange’s trading calendar.
The task of importing all this data and then getting it to a point where it can be managed homogenously is a huge one. The bigger a fund’s portfolio, the more likely you will end up juggling data sets from multiple exchanges and trying to shoe-horn them into a single reporting template. Hence, the need for more automation.
Similar issues arise if you have multiple market data providers. Inconsistencies can occur which will impact your ability to report effectively. Part of the role of your project team will involve bringing these data feeds together into a format that can be used for effective regulatory reporting.
Each party to the trade in your reporting system needs to have its own LEI (Legal Entity Identifier) code. This plays an important role in ensuring all data is being securely managed and that trades and their assigned funds are properly categorised and tracked.
Trading today is a multilateral exercise. Any proper reporting sequence is going to involve your counterparties. Hence, the data map would need to encompass each side of the trade. Significant seller activity needs to be tracked in an error-free format.
Transparency reporting requirements:
• Created as part of the MiFID II Directive.
• Any investment firm that transacts for their own accounts or on behalf of clients is obligated to report.
• Securities covered include shares, ETFs and derivatives, both on-exchange and off-exchange.
• Needs to be sent near real-time.
• Must be made public as soon as possible after the trade is executed.
• Trade reports must be sent to Approved Publication Arrangements (APAs) which are responsible for making the data public.
Transaction reporting requirements:
• Focuses on the parties involved in the trade.
• Increased number of data fields to be managed vs trade reports.
• Must include some counterparty data.
• Covers transaction-related data like time stamps and position size.
• T+1 requirement but not real time.
• Must be submitted to an Approved Reporting Mechanism (ARM).
• ARMs are tasked with maintaining transaction data and making them available to regulators upon request – e.g. to review risk exposure.
• Transaction data is not public.
Getting your data management processes right requires a significant investment in time and firm resources. Initial set up costs can also be substantial. This is regardless of whether an in-house or out-house solution is sought. It is very important that the data management processes are properly implemented and that they will function properly and serve your firm’s compliance needs appropriately.
Proper data storage facilities should also be in place, including all counterparty LEIs. This should be fully accessible by your own reporting systems.
Transparency reporting is an important part of your data management requirements: most exchanges now provide facilities that smooth the reporting process to the regulators and we would recommend that firms consider one or more of these. Euronext, for example, has introduced Approved Publication Arrangement (APA) and ARM facilities for both members and non-members. NASDAQ offers a similar service.
It is important not to underestimate the amount of work and investment that is required to get this right. MiFID II has required an enormous amount of effort from hedge funds to get to the point where they are fully compliant. Ultimately, we recognise that fund managers just want to be left to get on with running their businesses and are seeking solutions that will let them automate as much of it as possible.
Plenty of challenges exist when a hedge fund is asked to make this kind of fundamental change to the way they report their activity. The level of impact MiFID II will have on firms will vary from firm to firm. For some this will involve deeply profound change in which they report trades and manage data on a day to day basis. It is important for COOs at this juncture to closely consider the impact the new regime will have on costs. Is the reporting process too expensive at the moment, is it too manual?
There are lots of operational issues to deal with here. Many of the steps that need to be taken to achieve full reporting compliance have not been fully clarified. Unexpected costs can be thrown up purely through a lack of coordination of the many moving parts that exist within a hedge fund’s trading operations. For example, some requirements are almost impossible to derive from portfolio management systems, like the actual execution time. This stems partly from the fact that most portfolio management systems have no access to this information and have not fully adapted to the new regulatory requirements.
Hedge funds – and management companies – which find themselves struggling with these requirements should take a step back and consider the advantages that automating their MiFID trade and transaction reporting could confer. Cost savings and a reduction in regulatory risks are two of the key wins to be had here, but there are others.
Truss Edge is a technology firm that specialises in supporting fund managers with their data management and trade processing requirements, including regulatory reporting.