Much of the agreed-upon financial reform legislation calls on large banks and brokerages to improve their risk management functions, to help avoid another meltdown.
But fund managers also will have their share of work cut out for them. The legislation doesn't specify any operational or technological changes fund managers must make-yet the greater oversight of the $605 trillion over-the-counter derivatives market will require upgrading of front-, middle- and back-offices, to exchange data between different trading parties, clearinghouses and repositories.
Improved data management skills will also be needed on the part of hedge fund managers with more than $100 million of total assets under management, which will now have to register with the Securities and Exchange Commission.
Over-the-counter contracts categorized as standardized must be traded on exchanges and cleared through a central clearinghouse. The buying and selling of contracts will have to be reported to a trade repository, which will retain a golden copy of the transaction data. The Depository Trust & Clearing Corp.'s Trade Information Warehouse specializes in credit derivatives, while TriOptima specializes in interest-rate swaps. DTCC will also be launching an equity derivatives repository over the summer.
Just what classifies a major swap participant is ill-defined. Nonetheless, fund managers will still need to manage their relationships and risk exposures with not just one counterparty, but multiple clearing brokers and clearinghouses depending on the type of contract and where it is traded. The Chicago Mercantile Exchange, Intercontinental Exchange and LCH.Clearnet's services are just three of the choices.
The end result: software vendors predict an uptick in spending on electronic confirmation systems as well as collateral management, valuation and data management software.
"Some sort of electronic confirmation of the trade is a prerequisite to using a central clearing service directly, or even a broker/dealer clearing agent," explained Henry Hunter, head of product management and business development for MarkitServ, a joint venture between global data and OTC derivatives processing firm Markit Group and the DTCC.
Such a confirmation can be done through individual links with broker/dealers or through a service such as MarkitServ, which accommodates credit, interest rate and equity derivatives. It also eliminates the need for establishing connectivity to multiple broker dealers and can send the confirmed trade onward to the designated clearinghouse.
Yet more tasks for fund managers: they must reconcile their positions with counterparties, make margin calls and optimize their use of collateral.
"Fund managers will need to keep track of just what collateral they have posted with which broker/dealer counterparty or clearing firm, and the collateral requirements of each clearinghouse," said Tim Lind, managing director for strategic planning in Boston for Omgeo, which offers a post-trade reconciliation service for OTC derivatives.
Such practices aren't limited to centrally cleared trades. They also apply to bilateral transactions cleared between fund managers and broker/dealers because those trades also are likely to be collateralized.
At the core of efficient collateral management is also accurate valuation of OTC contracts. Some asset managers have hundreds, even thousands, of open derivative contracts on their books that must be marked for accounting purposes.
Relying on a counterparty with a vested interest will no longer cut it. Doing the work entirely in-house is also not feasible.
The credit crisis has accelerated the search for neutral third parties to provide independent assessments of what different derivative contracts are worth, according to Chris Zingo, VP at SuperDerivatives, a New York-based pricing firm. Other independent providers include Markit, Standard & Poor's and Numerix, as well as custodian banks and fund administrators.
"The data management requirements will increase as fund managers will be forced to reconcile with multiple central clearing services each with a potentially different view of market prices," Zingo said.
Fund managers trading OTC derivatives must also focus on aggregating their exposures.
"Such aggregation means data must be retrieved from multiple internal databases such as portfolio accounting, order management systems and securities master files," said Eric Bernstein, chief operating officer for Sophis, a cross-asset portfolio and risk management software firm in New York. "Those files must be kept accurate and consistent not only for risk management, but also reporting purposes."
While the legislation leaves it up to the SEC to determine just what registered hedge fund advisors will have to report, one operations manager at a New York hedge fund predicts the SEC will want to know how a fund's portfolio is performing and some details on what the hedge fund has invested in by industry sector, asset class and region. The regulator could even ask for information on just how leveraged the hedge fund really is.
Such an analysis means reconciling positions between front, middle and back offices as well as external counterparties such as prime brokers. And not just one.
"It's unlikely to be a big burden for the largest hedge fund managers, but smaller ones were relying on providing investors with detailed information on an ad-hoc basis as they accessed it manually from multiple systems," said Daniel Simpson, chief executive of Cadis, a data management software firm in London.
At the very least, hedge funds will need to put in place solid operating procedures that can withstand an SEC audit-and do so in writing. The price tag can come to as much as $1 million annually, by some estimates.
Among the key requirements for a compliance program are likely to be a dedicated chief compliance officer at all hedge funds, a code of ethics governing trading prohibitions on employees and conflicts of interest, customer account protections, e-mail retention, proxy voting policies and marketing policies, said William Mulligan, president of New York software firm HedgeOp Compliance. HedgeOp's software monitors trading activities of employees and keeps track of regulatory filings, best-execution records and anti-money laundering reviews.