Reducing the Risk of Innovation

Reducing the risk of innovation

Ralph Baxter, Director of Marketing and Strategy, ClusterSeven

It goes without saying that technology forms the backbone of all hedge funds, just as in any financial services organisation. However, technology managers in hedge funds face an extra set of challenges beyond those of their peers elsewhere in the financial sector.

Older firms in financial services have established infrastructures in terms of hardware, software, processes and personnel. They also have stable high volume transaction businesses. Although these are typically commoditised activities with low margins, they pay the bills for IT systems and have low operational risk. When these same organisations wish to pursue more innovative activities their costs are subsidised and their risk profile is stabilised by more mature business streams.

Hedge funds rarely have these dual benefits of cash flow and established infrastructure. Technology managers at these organisations must deliver services that provide the cost benefits of scale,without a flexible budget, as well as low operational risk without the equivalent business maturity.

The focus on operational risk is critical for institutional hedge fund investors, such as the pension funds. These are conservative organisations. While hedge funds fill a key piece of the high risk, high return part of their portfolio, they want exposure to selected market risk and certainly not unnecessary exposure to operational risk. For these reasons entry to the premier league of hedge funds is effectively conditional on demonstrating a low risk operational environment.

The provision of low cost and low risk services is a challenge that has been most effectively addressed for some processes by adopting outsourcing strategies such as prime brokers. This approach is highly effective for addressing the utility or commodity parts of the transaction processing chain – the outsourcer provides the benefits of lower unit costs by providing the same services to multiple clients. However, this solution cannot be easily applied to those technology elements that are unique to individual funds as there are few benefits of scale.

These challenges are compounded by the market environment in which the hedge fund makes its business: converting the expert knowledge of their analysts into product in order to capture profit and deliver competitive differentiation. The challenge for hedge fund technologists, therefore, boils down to how to deliver fast, innovative and competitive strategies with the lower cost and risks associated with mature solutions.

The result is usually a patchwork solution of IT systems; internal proprietary systems run alongside products from companies such as Sungard. It is interesting to note, however, that whatever the patchwork and whatever the fund, one component is always present – the humble spreadsheet. A map of any business process will show that spreadsheets act as the glue between the formal systems components. Their flexibility, user familiarity, speed and cost-effectiveness means that they are adapted to fill most gaps between existing systems and business needs (Figure 1).They fulfill multiple roles such as client reporting and the creation and testing of new products. Often, these new spreadsheet-based products then enter production environments while waiting for central systems to catch up. Even after formal migration into central applications, many users still keep the spreadsheet models to provide a consistency check and debugging tool.

These observations create an interesting picture. Hedge funds are under pressure to display low operational risk systems – which requires the minimum use of spreadsheets. Yet the way they make money – by being fast and innovative is an enormous driver for spreadsheet creation. So while all risk managers and auditors know that spreadsheets are not a robust long term support for operations, they are present beneath the surface of many business processes.

BUSINESS OPTIONS

This business practice has been implicitly accepted for years – not just in hedge funds but across many aspects of global commerce. For the hedge fund operations manager, however, implicit acceptance is not good enough; he or she has to articulate the control environment, which comes down to a choice between three approaches:

1. Maintain the status quo.

Too often this means that the role of central applications must be talked up and the true operational role of spreadsheets talked down – an uncomfortable tight rope to walk as risk moves ever higher up investor and regulatory agendas.

2. Adopt policies and programs to eliminate spreadsheets in all operational roles.

This has been tried and failed in many less innovative environments than hedge funds. In any environment full of bright, driven people who are increasingly aware of technology, it is almost impossible to stop them creatingtheir own solutions in a spreadsheet, which later becomes far too valuable to throw away.

3. Recognise the role spreadsheets but demonstrate control.

This has been the message from the Financial Services Authority in the UK through its spokesman in this area, Dean Buckner, who has made a series of presentations (1) in recent years on the use of spreadsheets in regulated financial firms. He is clear that spreadsheets represent a key part of the competitive edge of firms in the City of London and that it would be regulatory nonsense to seek to ban them. At the same time, however, he has emphasised the need for businesses to avoid simple denial of the issue and have a clear IT strategy for spreadsheets.

For many this has sounded good in principle, but perhaps created uncertainty as to what it would mean in practice. With recent focus in this area driven particularly by the US Sarbanes-Oxley Act, a better picture is starting to emerge. All of the major auditors are showing increasing awareness on the policy and process issues, with PricewaterhouseCoopers the authors of one of the most influential papers on analysing operational usage(2). Technology firms are also stepping in to meet the needs created by the pressure to reduce spreadsheet risk.

In order to understand the opportunities to improve spreadsheet practices, their integrity (i.e. assurance that the output is the expected processing of the input) can be viewed in terms of five key risk elements:

  1. The programmer of the spreadsheet logic model correctly understands the transactional process (i.e. correct specification)
  2. The programmer has created the required logic without errors
  3. Subsequent data inputs are valid (whether manual or automatic)
  4. Subsequent user and maintenance activity does not corrupt the original logic
  5. Where multiple user tasks are required on a spreadsheet, these are performed in the correct order.

The first two elements are linked to model creation, while the remaining three relate to the subsequent operational use of these models – when they effectively become business applications. It is the latter group that has received the most attention from regulators because over time they come to underpin critical financial activities but without clear business control.

HOW CAN TECHNOLOGY HELP?

Tools to address the potential flaws in model creation have existed for many years. They are reliant on pattern recognition in cell formulae or identifying error-prone logic elements. Clearly the almost infinite variety of potential logic requirements means that none of these tools can be 100% effective.

Once a spreadsheet enters operational usage the risks multiply because there are likely to be multiple users, not all of whom understand the structure of the spreadsheet. The most common solution is to impose some form of lockdown on spreadsheet change. This can be effective in highly resourced environments (where developers are on hand to change, test and re-issue a revised version within the timetable of business needs) or where the spreadsheet application has become very mature in its usage (i.e. business needs are not changing). Elsewhere this policy inevitably fails because it prevents the user exercising their own knowledge to resolve their own problems.

A second option is to use logic tools in the operational environment. However, these tools are usually inappropriate, as they need to be utilised after every user interaction, causing disruption of the business. They also require interpretation by someone who understands the underlying structure of the spreadsheet, which is less common in operational spreadsheet usage.

Hedge funds simply do not have the time or resource to apply either of these approaches. Fortunately a new generation of solutions is now available. These are specifically designed to address the operational usage of spreadsheets. By focusing on change management and user interaction, the business can expose all of the time-variant information contained within spreadsheets to explain the 'who', 'what', 'where', 'when' and 'why' for all changes. All of this can be done without imposing any extra overhead on spreadsheet users – they are free to use spreadsheets just as they have always done, or start to create added value from the historical dimension that is now available to them.

BENEFITS ACROSS THE OPERATIONS ENVIRONMENT

In organisations that have adopted such a solution it is interesting to see how business practices evolve through the recognition of beneficial opportunities within business teams, rather than enforced process change.

Firstly much of the monotonous checking of spreadsheets can be eliminated as effort needs only to be focused on what has changed. This checking can be made automatic by attaching alerts to critical structural areas of the spreadsheet or specific cell values. This allows the business to pre-empt potential problems.

New processes can also be tested before being placed in a live environment enabling trials of multiple process scenarios and reducing the risk of the formal live application.

Perhaps most importantly the quest for new opportunity can be accelerated. Historical spreadsheet information can be analysed to display trends in values and activities. As a result the snapshots of past states of the business held in separate spreadsheet files can be consolidated and manipulated fast. Data can be compressed, stored and reassembled for use in different ways. This means that the business can make informed business decisions more quickly. For example, reports driven directly from the history of changes can provide a quick way to identify what stage a transaction has reached and whether confirmation has been received.

THE FUTURE

Given the bond between users and spreadsheets, some may ask whether spreadsheet practices will ever change. A number of factors are now converging to make this a reality: firstly auditors and regulators are becoming increasingly vocal that the status quo is not satisfactory; and, secondly, there is growing acceptance that spreadsheets are here to stay, necessitating a holistic approach to the problem. But perhaps the most important step forward is the new ability to manage the whole spreadsheet lifecycle, whilst enhancing the power of the user to find more opportunity and make more money.

(1) See www.eusprig.org

(2) See http://www.pwcglobal.com/extweb/service.nsf/docid/CD287E403C0AEB7185256F08007F8CAA