Why Hedge Funds Go High-Tech

Why Hedge Funds Go High-Tech

Jos Stoop, Head of Financial Services Solutions, Interwoven
Originally published in the June 2006 issue

‘Investment’ and ‘returns’ are two words that can be immediately associated with the world of hedge funds – perhaps more so than ‘investment’ and ‘technology’, that is. But the latter is precisely what is happening in the buy-side market today – hedge funds, in particular, are starting to invest more in technology in order to create a robust operational framework and realise the highly-sought after goals of error-free, efficient, and real-time operational processes.

So is the age-old stereotype that the buy-side lags behind the rest of the securities industry in its attitude towards technology about to change? Perhaps so, and evidence is mounting as to the extent of this movement. There are several drivers behind this – including most notably the phenomenal growth in the number of hedge funds and the scale of their operations, regulatory and compliance pressures, the rising share of highly sophisticated financial derivatives in their overall product portfolio, and the development of specialised technology specifically tailored for the needs of hedge funds.

There has been a tangible shift in the market, ranging from start-up hedge funds through to the more established operators, of attitudes towards technology and infrastructure, particularly in the middle and back office. This has been exemplified over the past year by the focus the US Federal Reserve and the Financial Services Authority (FSA) have placed upon the backlog of outstanding confirmations that exists between the buy and sell-side in the Over-the-Counter (OTC) derivatives market.

As major sponsors of alternative investment strategies, OTC derivatives have been embraced by hedge funds looking to heighten returns from an increasingly competitive market. Those firms that were previously processing small numbers per day have seen volumes multiply spectacularly. Increasingly stretched operations staff, who don’t have the correct systems to deal with the influx of structured trades, frequently become unable to cope with processing such volumes.

FSA concerns

Casting a light into the convoluted world of OTC derivatives operations back in early 2005, the FSA issued a caution to market participants, highlighting its concern with the growing number of outstanding confirmations in the credit derivatives market specifically. At that time the credit derivatives market was, and still is, growing at a phenomenal pace and put simply, existing manual processes or back office systems – the plumbing in financial institutions’ operations – couldn’t cope in particular with the volume and complexity of credit derivatives trade confirmations being processed.

As a result, a high number of confirmations remained unsigned and unvalidated, causing a backlog to build between the buy and sell-side, as well as between sell-side participants. Those confirmations that were still outstanding after 30 days caused the most concern and posed the greatest risk, and it wasn’t unheard of for confirmations to remain outstanding for months, even years.

In July 2005, the influential Counterparty Risk Management Policy Group released a report urging the market to address the degree of operational risk that market participants had become exposed to, before the situation spiralled further out of control. With the FSA leaning heavily on OTC derivatives market participants on both the buy and sell-side, the US Federal Reserve put similar wheels in motion, calling a meeting with top executives of the 14 leading banks to discuss concerns surrounding operational risk management practices.

In order to avoid forced regulation, the major derivatives dealers committed to substantial reductions in the number of confirmations for vanilla credit derivatives outstanding over 30 days, primarily through increased use of DTCC’s Deriv/Serv matching platform for new trades, as well as dedicating time to resolving issues in the existing confirmations backlog. In addition, the leading dealers agreed to implement the Novation Protocol, an electronic messaging protocol developed by the International Swaps and Derivatives Association (ISDA) for trade assignments. Specifically designed to automate the assignment paperwork clogging up the back office, the protocol alleviates the problem by using electronic assignment messages to transfer existing trades to third parties rather than written consent distributed via fax.

Whilst the focus on the backlog of credit derivatives confirmations is a welcome response, the industry must take note of how the initial error rate for credit derivatives doubled from what it was in 2004, and how the backlogs for other derivative products continue to grow. Clearly, we are not out of the woods yet. In fact, much of the current focus is on streamlining and ‘cleaning up’ of bilateral transactions, both in terms of the current backlog, as well as making certain that newer transactions get processed in a systematic and automated manner. There is another entire set of transactions most participants have not even started to address with any degree of seriousness.

Post-trade confirmation processes

These are the post-confirmation processes and include specialised post-confirmation trade processes such as assignments (novations), allocations, amendments and settlements. This class of problem is more complex because there are potentially more players involved. Furthermore, with the increasing involvement of third-party intermediaries such as prime brokers, custodians, collateral managers and fund administrators, this class of trade processes is potentially much more complex than mere bilateral trade match and confirmations.

That said, the benefits of automated electronic processes in the back office are well documented, and such processes are used extensively by the sell-side to automate both structured and vanilla instruments’ processing requirements. Traditionally, take-up of electronic systems by the buy-side in the back office has been low, particularly with instruments such as OTC derivatives where best-of-breed systems are required to successfully cater for complex documents and processes.

Specialist providers have more recently taken their extensive experience with the sell-side and tailored their systems specifically for the needs of hedge funds and the buy-side. As a result, the market is seeing an increasing hedge fund uptake of systems that not only increase regulatory compliance, but reduce trade processing times by automating the confirmation process for OTC derivative instruments such as credit, interest rate, equity, commodity, FX and energy.

So most importantly – what has changed? The focus of attention by the regulators on this area has engaged hedge funds at a time when business growth has already placed a strain on operational processes and their existing infrastructure. The regulators have acted as the catalyst required to cause movement in the market, but in reality their input forms part of a trend that has been ongoing for the past 12-18 months. After all, it’s in the interest of all market participants to stay ahead of the regulatory curve and more and more participants recognise and accept this now.

The growth of the hedge fund industry has also been a huge contributing factor in the uptake of specialist systems. There are a large number of hedge funds that experienced phenomenal success – and growth – in a short period of time. Those that started out life as small operations have grown into larger firms, but the operational and middle and back office systems, staff and procedures, are often unable to keep up with that pace of change. Increasing trade volumes and under-investment in technology are two of the main factors for the lack of automation and systems deployment, and thus the increase in outstanding confirmations and associated risk.

Is it therefore fair to say that attention from the regulators was inevitable? Perhaps, although the increased media attention and heightened profile of the derivatives market will have played a role as well. After all, confirmation backlogs have been an issue for more than a decade, but never this widespread. The phenomenal growth and complexity of the OTC derivatives market has played a prominent role in the build-up of outstanding confirmations, and is another reason that automation technology is increasingly being deployed by hedge funds. By their very nature, the length and detailed nature of derivatives contracts means the potential for error is much higher than for exchange traded asset classes.

Ensuring that clean and validated data is populated in each field of an OTC derivatives contract is a lengthy and complicated manual process for many institutions. The ensuing error-rate is inevitably high, which results in a greater level of exceptions present in the workflow and therefore greater levels of unconfirmed trades, with manual exception processing facilities adding significantly to post-trade processing costs.

So could the investment community be mistaken for laying the blame for operational issues squarely at the feet of the buy-side? It’s true that historically-speaking the sell-side has been largely responsible for providing those systems required. However, there are other factors that have impacted developments that must be taken into account.

The high price of technology

Many hedge funds, buy-side institutions and mid-tier sell-side firms have previously been unable to justify the high price of technology required to achieve the objective of automation. The development of cost-efficient solutions that provide the buy-side with a solution tailored to their specific requirements has been key, with the incoming confirmation process being the main focus for many hedge funds. The market is moving quickly, and recent developments are enabling the buy-side to become increasingly focused on reducing processing time, supporting compliance and addressing trade failure.

The focus of attention in the OTC derivatives market over the past year has been successful in seeing new technology developed and implemented, and the numbers of unconfirmed credit derivatives trades decrease. In the past six months the backlog has decreased 50% to 74,000 at the end of March according to the FSA. More importantly, the number of trades that have remained unconfirmed for more than 30 days – those that pose greatest financial and operational risk – were down by more than 70% from 98,000 to 29,000.

With the total value of outstanding credit derivatives contracts approaching $17 trillion, it’s perhaps not surprising the regulators prompted some movement. The market was called upon to implement the systems required to embrace automated processing, and that has certainly happened to a degree.

However, it’s fair to say that the various initiatives ongoing in the market are yet to reach a level of co-operation whereby suitable standards and procedures are in place to ensure a reliable framework for consolidated processing of all OTC derivative instruments.

The surge in popularity of OTC derivatives has not, of course, been restricted to the more vanilla credit derivatives market – BIS statistics show that there has been a marked increase in activity throughout the more structured equity and commodity markets, and this certainly correlates with our experiences with clients.

These instruments have largely been excluded from automation projects to date, and there’s a danger the market will wait until similar problems exist before taking action. It’s therefore important that new solutions are multi asset-class and don’t focus on an isolated instrument category. It may never be possible to fully automate trading in highly structured off-exchange derivatives, but a significant part easily can be, which will go a long way to reducing risk in such a fast-developing market.

For the OTC derivatives market to continue to grow at such impressive rates it’s important that appropriate and tailored back-office processes are implemented to ensure that smaller and buy-side firms can manage risk effectively. In a world where regulatory attention and tighter margins are encouraging the streamlining of processes, a co-operative approach and innovative technology can go a long way to eliminating risk and solving bottlenecks in the market.