‘Remember Why We Started This?’

SWIFT's messaging infrastructure has a lot to offer hedge fund managers

Bill Gourlay, SWIFT
Originally published in the April 2006 issue

Early in 2000 I was fortunate enough to spend some time talking to the newly appointed COO of a brand new hedge fund venture. I remember the journey across town to his ornate West End office, the tiny lift and then the surreal experience of crossing the operational area. Four glass offices and two meeting rooms surrounded a small, but entirely adequate central area. In the middle of this was a single row of desks, probably numbering no more than 12, all with bright new chairs and untouched flat screen pcs. Clearly some money had been spent on providing a very pleasant area for the few operational staff that would be required, and I certainly marveled at the difference between this environment and my then employers' own operational floor which I had crossed earlier in the day. Our floor was closely packed with over 100 staff, seated at particularly tired desks, facing rather aged pcs, and apparently trying to accumulate as much paper as possible on their desks – whereas this was more like a show home!

The COO explained to me the exciting plans that he and his partners had for the fund. They expected that growth might take a little bit of time, but that their business model was strong, their fund managers were geniuses, and that they would bring on minimal operational staff in order to process trades and provide all of the associated reporting activities. After all, the fund managers had left a major investment bank because they were tired of the bureaucracy, the difficulty of altering a juggernaut's course, the constant management of numerous internal processes, and wanted to concentrate on the business of investment itself.

That is all history now, and in the subsequent years the readers of this publication do not need me to tell them how much the hedge fund, and fund of funds, industry has boomed; the model continuing to be, to try to focus on a lean and mean model using the most inventive investment strategies possible. So how could it be, then, that a couple of years later we hear that numbers of UK employees in the hedge funds industry are triple those working in the traditional funds sector? Whilst we know that the hedge fund business has become a highly attractive area, are we really to believe that there are that many people leaving investment banks to set-up their own funds business ? The truth, of course, is that all of this boom does not come without its own cost, and in this instance the cost has been attempting to deal with the operational requirements that such an active sector generates.

Perhaps it would be most realistic to say that, the hedge fund business has, to a certain extent been the victim of its own success. Often set-up to avoid the complexity failings of the traditional financial firm, by keeping processes as streamlined as possible, this has frequently not resulted in a particularly scalable model. Advanced technology that was used to form the foundation of the operational process, which may previously have been a source of differentiation from others (or was simply deemed to be a cheaper way to solve a problem than buying settlement systems off the shelf), has now become a more burdensome exceptional process. After all, how do you maintain or develop a complicated macro-based, or access-based solution, once the clever IT chap that you hired to build it, has moved on to pastures new ? Overall, the very purpose of breaking away from the constraints of the traditional large financial firm model has now been diluted as firms find that ever increasing numbers of operational staff are required, and genius fund managers find their people skills are more often used managing internal issues as company directors, than their analytical skills as investment professionals.

Learning from operational departments

However there is a solution out there, and if it's not heresy to say it, here, the hedge fund and its service providers can learn from those sleepy old traditional operational departments. For whilst the hedge fund business has been acquiring assets and staff in equal measure, those traditional firms robust enough to survive a very aggressive period of mergers, headcount reductions and budgetary constraints of the last few years have been sharpening up their act. Almost entirely gone are the piles of paper and the exceptional processes in favour of automated procedures which do not require high levels of manual intervention. (I was even made aware of one particular gentleman whose objectives were measured on the basis of the reduction of boxes of printer paper ordered from the firm's stationers!). Automation has given custodians, brokers and fund administrators a real level of scalability which has meant that increasing volumes of trades can be processed, whilst in many cases the number of staff required to effect this has reduced. The scalability has been coupled with levels of system availability and resilience which has had an enormously beneficial impact on the reduction of risk in this business, has a number of obvious reputational advantages, and puts the foundations in placeto meet the various regulatory challenges of MiFID, Giovannini and others.

The key aspect behind all of these processing benefits has been the enhancement and increased adoption of ISO standards. These standards have provided the industry with freely available message formats covering everything from orders to confirmations, foreign exchange to payments, corporate actions to collateral, and more recently full sets of messages for the funds industry. The funds messages additionally allow subscriptions, redemptions, switches, transfers, NAV calculations, holdings statements, transaction statements and cash liquidity forecasting information to be passed between firms in a consistent fashion. When these messages are carried across an infrastructure with inherent resilience and cost efficiency, such as SWIFT, then the associated benefits quickly become obvious. With volumes of over 2.5 million funds-related messages passing over the SWIFT network in the first two months of 2006, it appears that this fact is not lost on the industry !

In an environment where standardised messages are being used across such a network, the ease of communicating with your counterparts becomes infinitely more simple. You know that the messages you receive will be in a certain shape, so can be automatically processed through a back-office system, and if they're not in the right shape they will be returned to the sender to be amended. You can build systems with one information model in mind, rather than having to allow for numerous different sets of proprietary data. You can take on new counterpart relationships without lengthy periods of testing, or getting to know each other's various operational foibles. Most importantly perhaps, you are also able to choose your business relationships based on those firms with whom you want to do business, and on those that provide you with the best levels of service, rather than being tied up in a relationship where the biggest bond is the amount of exceptional processes between you.

We know of a number of firms who have adopted these messages for their funds business in the last year or two, and who are already seeing significant savings in their staffing requirements. Volume increases that would have previously needed an additional 10 to 20 headcount are now being absorbed without the need for any increase at all. Other firms who were previously renowned for keeping taxi firms in business, shipping their staff home at all hours of the night, are now able to offer their staff the rather more enjoyable benefit of more regular working hours. Documentation is able to change hands in fractions of a second, rather than braving the lengthy journey to the fax machine and the constant threat of the empty paper tray.

Taking these steps forwards will produce a greater level of confidence that the operational process will work properly, and will be sufficiently transparent to meet the requirements of any risk officer or regulator. Messages sent in the correct format will end up with the right counterpart, they won't disappear, and when they are delivered will be recorded as delivered by a neutral party who can mediate in the unlikely event of any discussions regarding whether and when it arrived. The messages themselves can also evolve with the changing needs of the marketplace, through the benefits of market practice initiatives and message use rulebooks.

The benefits of better messaging

The benefits that this gives to client servicing are also often greatly underestimated. Being able to process data quickly and accurately allows positions to be updated extremely promptly, providing a reliable source of data for onward reporting. Client facing reports can still retain those particular details or formats that provide the service differentiation factor, but the core information on which they have been built can be relied on as the latest available. There are today, still numerous surveys which quote the biggest factor driving investment changes as beingadministrative dissatisfaction, rather than particular performance issues. So whilst the impact of correct client data may be considered a neutral factor, the provision of incorrect information to a client is considered as being decidedly negative.

While it may have been the hedge fund managers who ran away from the traditional financial services players in order to benefit from greater freedom and efficiency, it would now seem to be a very good time to take a look back and learn from the advancements made by these traditional firms. Automation and the use of standardised messages across extremely reliable networks has brought a level of scalability which can provide streamlined processes strongly in line with the original ethos of the lighter hedge fund operation. Cost levels have decreased, latency improved and messages are available for the vast majority of the fund lifecycle. The opportunity for benefit is open for the manager, administrator or prime broker, and this is a fact that has not been wasted on a number of market leading hedge fund firms already.

As my COO contact said at the time, "We're here to allow our fund managers to invest as efficiently as possible, to take advantage of whatever technology is available, and to concentrate on what we do well". Not surprisingly, he is now a user of standardised messaging across our network, and the fund managers are free to concentrate on taking the fund from strength to strength.

SWIFT is the industry-owned co-operative supplying secure, standardised messaging services and interface software to 7,800 financial institutions in over 200 countries. SWIFT has a strong partnership with the investment management industry. Over 350 investment management institutions are now using SWIFT to facilitate end-to-end straight through processing in funds, securities, treasury and payments. SWIFT has increased its value proposition to the investment management industry through the launch of comprehensive fund messaging standards which allow investment managers, hedge funds, distributors, and administrators to reduce the operational costs and risks inherent with manual processing and to enhance their scalability and service levels. In 2002, investment managers became full shareholding members of SWIFT for the first time.