By Leigh Walters, Global Head of Sales, Omgeo
The middle office operations of European hedge funds, where trades between counterparties are matched and confirmed, has historically received little investment from hedge funds when compared to the front office spending, as well as little attention from investors, regulators or board members. However, post- global financial crisis, this reality has changed dramatically.
Hedge funds investing across markets and asset classes, and particularly those focused on equities and derivatives – including CFDs (derivatives in nature, if not in name) – are facing an avalanche of new rules and requirements aimed at reducing credit, counterparty and operational risk. A number of these rules are due to be finalised or implemented within the next 12-18 months, and are sure to have an operational impact on firms worldwide.
Mounting compliance requirements and a growing focus on operational due diligence means that there is more interest in the middle office than ever before. Investors too are looking at risk management processes across the entire operation of the hedge fund, to the extent that an ability to demonstrate robust risk management processes could influence investors’ choice of where to invest their money.
Big Changes Ahead
Four areas in particular are due to impact the middle office operations of European hedge funds. These include:
1. A move to shorter settlement cycles for equities and fixed income trades. The European Commission published in March 2012 its proposals for Central Securities Depositories harmonisation and for improving settlement efficiency. Known as the CSDR, the proposal includes measures for the harmonisation and shortening of settlement cycles (SSC) in Europe to T+2, and for financial penalties to be levied at firms that fail to settle within this deadline. The CSDR will mandate a move to T+2 in all 27 EU member states from January 1, 2015 so that it is implemented prior to the adoption of Target2 Securities (T2S), a pan-European clearing and settlement system, in June 2015. It is currently before the European Parliament and Council of Ministers for final adoption.
A shorter, harmonised settlement cycle is expected to have a risk mitigating effect across the industry, but it is also anticipated to result in business benefits for hedge funds. There are few barriers to achieving shorter settlement cycles, however, all market participants, including hedge funds, will have to become quicker at progressing the pre-settlement stages of the trade lifecycle, namely, trade confirmation in order for SSC to be achieved.
2. A move to central clearing for derivatives. In an effort to make the over-the-counter (OTC) derivatives market more transparent, policymakers have been creating rules under the European Market Infrastructure Regulation (EMIR) that will result in the majority of OTC derivatives instruments being traded electronically and cleared through a central counterparty (CCP). To protect against counterparty defaults, CCPs will require its members to post high-quality assets as collateral. European policymakers are currently developing the collateral obligations for bilaterally cleared instruments, which are due to be announced in the coming months.
Concerns over a collateral squeeze as a result of the new rules have already surfaced and smaller hedge funds in particular need to make sure they are able to make the best use of the collateral they hold. This task will become increasingly challenging in a mixed, bilateral and centrally cleared environment, and hedge funds should begin to review their collateral management procedures before the clearing requirements come into effect in Europe.
3. Greater scrutiny around contracts for difference (CFDs). As regulatory change in the derivatives market begins to take shape, one area that remains far from unambiguous is the status of CFDs. Questions are slowly mounting over whether CFDs will be classified as an OTC derivative, thereby qualifying them within the scope of EMIR. If so, it is possible that CFDs will also become subject to clearing requirements.
Moreover, it has been well documented that in February this year, the European Commission adopted the proposal for a Council Directive on a financial transaction tax (FTT), applicable to the 11 EU countries that have agreed to follow the cooperation procedure for the tax. While most of the operational details around this are yet to transpire, the scope of the asset classes and transaction types covered specifically includes CFDs. What impact this will have on volumes remains to be seen.
4. The introduction of a “barcode” for hedge funds. The legal entity identifier initiative (LEI) is aimed at providing regulators with a mechanism through which to monitor and mitigate the build up of systemic risk in the financial system. Eventually, every legal entity of every participant in the financial markets, including hedge funds, will be required to have an LEI – a unique ID associated with a single corporate entity or fund.
This eventuality is likely to come sooner rather than later as there has been good momentum towards the implementation of the LEI initiative to date. The simplest way for hedge funds to view the LEI is as an extension, or enhancement, of account and standing settlement instructions (SSIs), which are already maintained and communicated between counterparties so that trades can be settled. To be compliant with the LEI, once implemented, hedge funds should start to assess the accuracy of their entity reference data, which, as best practice, would include legal name, trading status, date updated, aliases, BIC, and registered and operating addresses.
Middle Office Under the Spotlight From Regulators and Investors
In addition to the new rules outlined above, recent cases of shortcomings in middle office procedures at high-profile investment firms have highlighted the hardened resolve of policymakers and regulators to take action against risk management failings. Not only have these cases caused reputational damage to the firms involved, but, regulators argue that such failings puts investor confidence at risk across the wider financial markets. As such, it is imperative that hedge funds demonstrate that they have both an accurate and holistic view of their exposures, as well as the ability to measure their risk at any given moment.
The spotlight on the middle office will, in the first instance, require hedge funds to review the existing processes and procedures through which they confirm, clear and settle their trades. This year, more than ever before, we are likely to see the implementation of new rules that will require hedge funds to take action – and the preparations for those changes need to start now.
An efficient, sophisticated middle office will become strategically important to the overall business of a hedge fund, the asset classes they invest in and the geographical markets they target. Firstly, it is now commonplace for investors to provide requests for information (RFIs) to potential fund managers and, increasingly, importance is being placed on operational controls and systems. Investors only want to take risk from the portfolio, and not from inherent operational risk. Therefore, in today’s competitive landscape, fund managers can win or lose lucrative mandates based on middle office sophistication.
Secondly, in terms of asset classes and geographies, the mixed clearing requirements (whether this is OTC bilateral, centrally cleared or exchange traded) will mean a much more complex set of collateral requirements and transparency. And, FTT will lead to some asset classes and geographical markets becoming more or less popular depending on their classification and subsequent tariff. All of these items are increasing the workload for the firms, but adding headcount does not solve the issue due to cost and risk of human error or fraud – and it does not help middle offices adapt quickly to changes in the investment landscape. Taken together, these issues mean that automation is becoming intrinsically important to firms.
Middle Office Rises in Importance
The middle office has, in truth, traditionally been viewed as a cost-centre; much lower in the pecking order of importance than portfolio managers and the front office. While changes in this mentality have emerged in recent years, the next 12-18 months are likely to be a tipping point. An efficient, sophisticated middle office will become strategically important to the overall business of a hedge fund, the asset classes they invest in and the geographical markets they target. Risk and regulation will continue to drive enhancements in the middle office, but the most forward thinking hedge funds will demonstrate a real commitment by investing in their middle offices, unprompted by regulation.
Omgeo is a global financial services technology company. It automates trade lifecycle events between investment managers, broker/dealers and custodian banks, enabling 6,500 clients and 80 technology partners in 52 countries around the world to process trades in a standardized way, according to industry best practice. https://www.omgeo.com/