Hedge Funds and Dodd Frank

Is there anything that’s certain?

Originally published in the August 2012 issue

Since the Dodd Frank Wall Street Reform and Consumer Protection Act was signed into law, most of the required regulations have not been finalised and the effective dates of many finalised rules have not yet been reached. As hedge funds put plans into place to deal with the increased data and reporting requirements associated with the legislation, uncertainty about the full impact on daily business weighs heavy on the minds of most hedge fund managers.

Does the uncertain legislative landscape breed fear in hedge fund boardrooms? Some wonder, “Is there anything that’s certain about Dodd Frank?”

This article will examine what is known about Dodd Frank, known compliance challenges like Form PF, what areas of uncertainty remain, and how hedge funds can stay on top of changes to plan for the future.

Summary of Dodd Frank
The Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law on 21 July 2010. Intended to address problems in the financial system that made headlines during the economic downturn of the late 2000s, Dodd Frank promised sweeping reform in the financial community. Made up of 2,300 pages and 243 separate rulemakings by 11 different federal agencies, the legislation aims to: “promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail”, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”

The Congressional Budget Office estimated that the Act would increase federal government revenues and direct spending by $13.4 billion and $10.2 billion, respectively, between 2010 and 2020, and those effects were projected to reduce deficits by $3.2 billion.

Currently, Dodd Frank regulations continue to be delayed, its rules change frequently, and there’s uncertainty about which government body will govern what. While waiting for the next round of Dodd Frank regulations to be passed, uncertainty continues to weigh heavily in the financial markets.

Despite this, daily business operations churn ahead and hedge funds are beginning to cope with several Dodd Frank regulations that have already taken effect or are about to. The most talked about new requirement is new Rule 204(b) 1, which stipulates that Private Fund Advisers — defined as SEC-registered investment advisers with at least $150m in private fund assets under their management — must make periodic filings on the new Form PF. Only Private Fund Advisers who are registered with the US Securities and Exchange Commission (SEC), including those that are also registered with the US Commodity Futures Trading Commission (CFTC), must file Form PF.

With the main intention of protecting the US economy from the occurrence of another 2008 crisis, Dodd Frank changes the overall regulatory structure… but how exactly?

What’s next?
Will there be further delays and postponements in the adoption of new rules during the remainder of 2012? Can we expect more legislative activity in the second half of the year with the Presidential election looming? Or will a lame duck Congress put off action until 2013?

Nothing is really certain, except change. When legislative momentum does begin to accelerate, will there be any assistance from the government (e.g., FAQs, advisories, etc.) to help hedge funds understand and synthesize all of the changes and new rules? Simply understanding the meaning of some of the new rules has been difficult for some. The situation becomes much more complex when the large number of regulatory bodies involved is taken into consideration. “Is anyone certain where the new rules will be coming from?” is a common question in the financial community. And that comes before the multitude of questions involving compliance.

Most hedge funds are not in the business of sitting and waiting for answers. So what is the recommended course of action in a situation like this? This isn’t the first time the financial market has faced uncertainty over major legislative changes.

Let’s take a look at the real challenges.

On the whole, the financial community has accepted the concept of higher reporting requirements under Dodd Frank. From a day-to-day business perspective, the increase in federal and state supervision equates to the need to provide more, and better, data. What does this mean for your firm? More work, more resources — and higher costs? Not necessarily. It does mean that it’s time to put best practices in place to ensure that your firm, staff, and clients stay informed, prepare for what may be next, and are ready to make the necessary changes, when they do happen.

What’s the most important commodity in a time of uncertainty? Information. In unpredictable times, it’s absolutely critical to stay on top of news, deadlines, milestones, and postponements. It’s also essential to stay closely attuned to what both clients and competitors alike are doing to stay informed. Staying one step ahead of your clients is key.

For hedge fund managers it is now common to have search engine email alerts set-up to monitor Dodd Frank and other regulations. The email alerts provide an essential and timely way to stay on top of legislative news and developments. On the opposite end, a long-term strategic plan should be in place for the hedge fund that carefully lays out how your organisation plans to communicate with your investors and clients about Dodd Frank developments and their impact.

The fact that Dodd Frank presents a steep learning curve for everyone involved must not be minimised. Your information gathering and communication plans should keep the long view in mind. New rules will continue to appear, along with revisions to those rules. And after that, there will be more new regulations. The information flow must be ongoing.

Planning for what is actually known about Dodd Frank regulations is the ideal place for firms to focus on in early 2012. Let’s take a look at some of the specific impacts that you can begin planning for:

• An increased number of forms
• A higher level of granular reporting detail
• Integration of information from multiple systems
• Workload planning – stretching the bandwidth of existing personnel and training new hires
• Increased costs – for staff, data, and/or systems

The changes listed above are not solely the result of regulatory changes. Increased reporting requirements have also resulted from new, increased client demands. In fact, many hedge funds are now considering major technology overhauls of their portfolio management and accounting systems.

The new demands on hedge fund managers, especially for those at large funds, are growing rapidly. They not only have to be able to manage cash; set up, value, monitor, trade, and settle a wide range of complex financial instruments; oversee aggregate counterparty exposures; keep track of their collateral, and evaluate results; but now they must also meet new greatly expanded reporting requirements.

Another essential requirement is being able to demonstrate to existing and prospective clients that sound financial and operational controls are in place. All of these demands combine to require powerful and flexible technology systems built by companies that truly understand hedge fund investments.
“For smaller hedge funds, meeting increased information demands may be even more difficult since the necessary infrastructure may not already be in place. The majority of these managers will look to their fund administrator and to technology providers for risk aggregation and reporting solutions,” according to Keith Caplan.

Firms can, and should, use the delays associated with the enactment of Dodd Frank regulations by working to finalise their information technology and compliance structure, particularly regarding accounting, recordkeeping, independent valuation, and risk management. Since the regulatory changes will stretch across the next few years, it’s certain there will be even more work ahead. Looking for operational efficiencies now will help soften the impact that Dodd Frank and other regulations may have on your business later.

Remember – change isn’t always easy or fast. For economic reasons, you may want to consider transferring business processes (like technology and/or registration) to third parties. On the technology side, this can help reduce the total cost of ownership since it eliminates the cost of in-house hardware, expertise, and support. The use of third parties can also have a beneficial side effect from the client’s perspective – those who are looking for increased transparency and reliable data perceive the use of third party vendors as a positive move.

Are you ready for Dodd Frank-related deadlines? If your firm isn’t prepared, you have a lot of work ahead of you.

Form PF’s primary purpose is to enable the Financial Stability Oversight Council to collect empirical data to monitor systemic risk in US markets and to coordinate with international bodies to examine systemic risk. “If you haven’t started planning for Form PF – be forewarned – Form PF is a project, not paperwork. It must be a highly coordinated effort among IT, legal, compliance, operations, finance and accounting”, says Keith Caplan.

The information requirements encompass fund assets, liquidity, leverage, credit risk exposures, trading positions, and investment positions, among others. For large hedge funds, the SEC estimates it will take about 300 hours for the initial filing and 140 hours for each subsequent quarterly filing. Smaller fund advisors will require an average of 40 hours or more to file the required information in just one section of Form PF initially and then spend 15 hours on subsequent filings. These figures include the cost of new programming that may be involved to obtain the reports required for filing. Even the SEC acknowledgesthat Form PF will result in an increased demand for technology resources.
The data collection effort required for Form PF is going to be substantial for all hedge funds. “For large funds, complying with Form PF is going to require a heroic effort,” says Philip Lawton.

Firms now must be able to hone the information in their accounting systems down to a very fine level of granularity. And, they have to be able to sort that information and roll it up in new ways to meet these new reporting requirements. For some firms, the data may already exist. Unfortunately, it may reside in disparate systems. Hedge fund Chief Operating Officers, Chief Compliance Officers, Chief Financial Officers, and Chief Technology Officers should be discussing and preparing for the new information requirements. Even well-managed firms that are confident their accounting systems are in order should be ready to face steep data management challenges.

“The CFTC too has increased its reporting requirements. Many formerly exempt private funds and mutual funds must report on Form PF or the CFTC’s equivalent,” says Keith Caplan. “These new CFTC requirements increase the required scope and flexibility of the reporting and workflow systems”.

Regulatory developments aren’t happening only in the US. They’re on the horizon for hedge funds worldwide. In Europe, hedge funds will face the Alternative Investment Fund Managers Directive (AIFMD) some time in 2013, requiring registration with national regulators. Like Form PF, the Directive will have increased disclosure requirements of greater frequency and capital requirements for hedge funds. Non-European Union managers who market funds in the EU are also going to be subject to increased reporting requirements. There are no safe harbours.

And remember Dodd Frank is just the start of major regulatory change in the financial community. Your systems and workflows need to help you manage compliance with Form PF, but also help you be prepared for additional compliance challenges to come.

It’s undeniable that hedge funds are bearing an unusual burden as a result of Dodd Frank legislation. The large number of new information requirements, combined with increased client demands, have brought with them data management and bandwidth issues, and perhaps, higher costs for hedge funds. In the end, regulatory change is an important driver of technological change. This is the right time for your firm to evaluate whether your existing technology will meet the ongoing demands of Dodd Frank and other global legislation.