Open Platform

Hedge funds and challenges of STP

Alberto Fontana, Managing Director, Financial Tradeware
Originally published in the June/July 2005 issue

Operational failures are commonly acknowledged as the main cause for hedge fund collapses, and it is clear that the strength of the underlying operational processes alone can provide additional insight into the sector's longevity. Hedge fund managers must begin to prioritize the efficient running of processes that mitigate operational risk in continuing their search for alpha. Appropriate risk management tools with increased levels of transparency for investors must also be considered – private investors, pension funds and investment funds have all indicated an interest to become more closely involved.

Increased regulatory pressure is also having a strong impact on the industry, the extent of which is currently unknown. An example is the introduction by SEC of the compulsory registration of hedge funds with 15 or more US investors and $30 million assets under management. We are also going to experience the knock on effect from European regulators regarding their request for higher levels of transparency, more frequent disclosure of net asset value (NAV) calculations, and higher attention to risk management.

In order to be competitive, maximize profit margins and minimize the risk associated with the dynamic environment in which hedge fund managers operate, it is essential to identify and implement the most effective technology to fully satisfy the industry specific requirements, both regulatory, and to create alpha for clients.

The choice of the right technology solution is highly subjective and strictly dependent upon the strategy applied by a given hedge fund manager. In particular, with the increasing use of complex products, highly diversified areas of investment and geographical coverage, the route to straight through processing (STP) is far more complicated than for more conventional asset management institutions.

The majority of new hedge fund managers who come from larger institutions will quickly realize that the IT processes and support they had become accustomed to are no longer available to them. The challenge for these managers is to understand the full range of requirements associated with creating and managing an IT infrastructure. These requirements include automating the trade executions with a number of prime brokers, completing the clearing and settlement process with custodians, dealing with exceptions, providing reports to investors, ensuring that pricing inputs are correct, and reconciling trades at the end of the day, to name but a few.

Given the range of tasks, it typically becomes a challenge to deal with these issues, mainly due to hedge funds' common lack of IT experience. Most new hedge funds tend to outsource a large part of their IT development and on-going management to a prime broker or third party with experience in working with hedge funds – including start-ups – and this can lead either to costly bills from the third party or high commission rates from the broker. Hedge fund managers realize very quickly that their competitive advantage lies in their investment decisions,not in managing operations. Therefore, technology has a crucial role to play in tackling this challenge and in improving the governance of funds as well as the level of automation and efficiency.

Cost-effective and accessible technology

The good news is that there is technology available on the market to help hedge funds, and it is more accessible and cost-effective than ever. Hedge funds are in a favorable position to implement the most modern technologies as they are not dependent on legacy systems and have a smaller and more flexible structure. Currently many hedge fund traders prefer to limit their IT infrastructure to a data provider feed and to update their portfolios on Excel spreadsheets, while processing trades over the phone. This doesn't happen interactively and requires a high level of manual intervention – there remains a high risk of human error.

On the other hand, I have witnessed the selection of multiple packages as a common option, which is often forced by the circumstances of having a small number of highly specialized traders following different markets and applying different strategies. This, however, involves a very complicated customization process and it is not always possible to integrate these systems together. The immediate consequence is represented by substantial bottlenecks for the back-office operators, who are forced to retype key data a number of times, thereby increasing operational risks. Furthermore, these bottlenecks inevitably produce backlogs and delays in the real-time representation of the fund's results, the calculation of its NAV, and precise risk exposure.

If an efficient reporting system is installed, the three layers of reporting can collapse into one and generate three clear advantages: the reduction of time spent reading and typing the same data on multiple occasions; a lighter burden to the administrators and auditors (leading to good economies for all participants); and the option to convey the profit and loss position, even intraday, without giving the trading strategy away.

With the use of one end-to-end system rather than multiple software packages, it is possible to be fully compliant with the upcoming regulators' requirements. Valuations will be more reliable and information properly disseminated.

Unfortunately, there have not been many products tailored to the requirements of hedge funds. The few that do exist are extremely expensive and highly specialized in particular areas of trading or markets. In most cases these software applications are re-adapted from more general investment banking solutions and fail to provide flexibility and scalability to hedge fund structures.

Achieving STP is more complex than forecast

The achievement of STP in this market is proving to be more complex than forecasted. Substantial sums of money have been invested, but we are still far from seeing the real benefits of end-to-end automation of operational processes. We have witnessed some progress in the last few years, but major problems exist with the more complicated products commonly used by hedge fund traders which are highly specialized. Hedge funds require fully integrated products covering every organizational area and internal procedure. In addition, the solution has to provide a high rate of flexibility, easy customization, scalability, compliance, and transparency for clients.

Advances in technology are starting to ease this process by providing developers with more flexibility to develop software at a lower cost, leading to savings which can be passed on to end users. With Microsoft's .Net infrastructure, development has been simplified, adding functionality that increases flexibility and scalability – this is a major advantage for smaller and flexibility-dependent hedge funds. The fact that .Net technology is more user-friendly will encourage smaller financial institutions, such as hedge funds without IT departments, to consider purchasing an STP solution.

Another crucial factor is represented by standards convergence – a crucial factor in the automation process. Today it is possible also for hedge funds to connect to the SWIFT network indirectly and at more competitive cost via Closed User Groups, enabling them to exchange standardised financial messages (e.g. FIN, FIX, XML), with their financial counterparties via the SWIFTNet secure IP network, and automate their "core" activities, benefiting from a single and highly secure industry recognized channel. Thanks to the newly introduced SWIFTNet infrastructure and its complementary messaging services, FileAct, InterAct, Browse and FIN, users are able to exploit a single, secure communications channel to send and receive messages – automatically or manually – to and from the Service Administrator who has direct access to their various correspondents using the SWIFTNet network.

An ever-increasing number of market participants, both domestic and global, are benefiting from a secure connection to over 7650 SWIFTNet correspondents. Investment managers, broker-dealers, custodians, security depositories, clearing organisations, exchanges, electronic trade providers, transfer agents and fund administrators rely on SWIFT to reduce the complexity, risk and cost of their domestic and international transactions. SWIFT facilitates standardised communications and processing at all levels of the lifecycle of equities, fixed income, derivatives and investment fund transactions – from trade execution through to settlement and custody services.

A complete solution that benefits from the use of industry recognized standards, would then give smaller hedge funds a competitive advantage in the form of independence from expensive service providers, brokers and custodians. By eliminating these links of vital non-competitive dependence, the efficiency and profitability of smaller organizations' structures will be maximized.

Hedge funds can leverage a great advantage in this battle as their decision making process is faster and less bureaucratic than in investments banks, meaning they can adapt to change more quickly and implement software solutions more rapidly. This will allow them to maximize their operational efficiency and concentrate on what they are specialized in and born for – trading.

Alberto Fontana is a managing director of Financial Tradeware, a London-based vendor of STP portfolio management and brokerage software.