01 November 2007 Features

 

Compliance takes centre stage

Matt Grinnell

Once a bit-part player, compliance has taken on a starring role at most asset management firms. Where it was once an activity that occurred only at the end of the trading period, usually involving a quick flick through the portfolio, it is now an essential pre-and post-trade activity. Consequently, using some form of compliance technology has become a recognised imperative.

But that recognition is felt not just by portfolio managers and traders. Compliance has become a significant element in the calculation of operational risk, blurring the lines between the two previously separate departments. So much so that it is often the risk department that is now involved in the purchasing and implementation of compliance technology.

This has had an impact on the status of compliance within the organisation. Whereas regulatory or mandate breaches were self-contained events that posed problems for the individual portfolio or fund manager, operational risk has always been viewed, rightly, as an ongoing threat to the success of business. As a result, risk management has traditionally been an executive-level concern.

But now, when the impact of a single compliance breach can be felt throughout the organisation in terms of financial and reputational cost, compliance has been elevated beyond the trading desk to join risk in the board room.

The most obvious reason behind this enhanced status of compliance is the tighter regulatory climate in which asset managers – and, increasingly, hedge funds – are operating.

Aside from the corporate governance and anti-fraud requirements contained in Sarbanes-Oxley and other similar pieces of legislation, amendments to the US Investment Advisors Act and the arrival of MiFID have forced tighter internal compliance monitoring and more detailed reporting on both sides of the Atlantic. With more regulation there is naturally more opportunity for breaches to occur, and with higher penalties for those breaches, they become a far greater risk.

However, it is not just the regulators who are paying much closer attention to trading decisions. The trend towards transparency over the last few years has encouraged investors themselves to scrutinise their portfolios more closely. Of course this too has largely been driven by high-profile corporate scandals. When Enron, Worldcom and Tyco collapsed, their pension funds went with them. A more informed client-base is questioning the procedures that are in place to ensure that their portfolios are being managed in line with mandates.

The other driver for closer client scrutiny is that the size of investment is typically larger than it has been previously. With bigger nest eggs placed in the hands of fund managers, investors are demanding assurances that their money is being managed effectively and that they will not lose their shirts.

Demonstrably effective compliance procedures have become, therefore, a key market differentiator, with clients voting with their wallets about which methodologies they prefer. Any breaches that do occur are likely to cause many existing investors to start looking elsewhere for a more reliable and safer pair of hands in which to place their money.

But, if the size of the investment is a major driver, then so is the composition of the fund. Returns from ‘safe’ investments in bonds and low-risk equities have largely stagnated, the occasional ripple notwithstanding. Consequently, asset managers are broadening the scope of the portfolio, incorporating a wider array of exotic instruments, alternative industry sectors and a wider geographic coverage in an attempt to secure those elusive margins.

This search for greater returns has led to greater complexity within portfolios and, consequently, more intricate mandates from clients. And, like the increase in regulation, the more prescriptive the mandate, the more opportunities there are for breaches to occur.

So compliance has become an intrinsic part of the operational risk calculation at asset management firms. This trend has been emerging for several years – but it is now having an impact on the kinds of technology used. Those firms that have chosen to use proprietary systems over vendor-supplied solutions, and in fact have never bought in vendor products before, are starting to make the transition to these systems.

Because risk management was historically a front-to-back operation and compliance purely a back-office function performed at the end of a trading period, it was usual for firms to have two separate systems. Many are now recognising that buying in a single solution that can handle both is more efficient and more effective than continually developing two separate in-house systems.

They also recognise that vendor systems have the capacity to add value – from trading desk to risk management committee – rather than simply adding costs to the organisation. In particular it is the pre-trade compliance functionality which can prevent compliance violations downstream that is winning over firms previously wedded to home grown systems.

Today’s buy-side compliance engines are designed to enable asset management firms to define workflows and provide them a stable means of viewing activity. As trading becomes an increasingly global, 24-hour activity they monitor compliance to rules from all of the world’s major regulatory bodies in real time, updating as new directives come into force. In doing so, they highlight and prevent potential problems before they become a breach. Data from these compliance systems are now an essential part of operational risk calculations and make a significant contribution to a firm’s ability to reduce its exposure on both an individual fund and company-wide basis.

But equally important, systems supplied by third parties have, or rather should have, the ability to be updated rapidly to reflect changing concerns and market issues. They have to be able to scale up to handle the escalating volumes of trades that now characterise the market, without any loss of performance.

The recent widespread adoption of derivatives is another portfolio management strategy that needs the appropriate technological support. They cannot be traded in the same way as traditional instruments, but are notably higher risk than bonds or equities. Again it is vendor-supplied systems that are most likely to be able to handle the rapid pace of change.

That technology is required to manage compliance has been an accepted truth within the industry for some time. That compliance and risk are intrinsically linked is also widely recognised. But now there is a growing realisation that the needs of the risk department, incorporating compliance, are best served by third party providers, whose technology and expertise is focused on producing systems that are best suited to asset management firms, whatever the prevailing trading conditions.

Matt Grinnell, compliance consulting manager, Fidessa LatentZero