Hedge funds need a flexible, adaptable risk management system capable of delivering information to multiple stakeholders: regulators, investors and internal risk and compliance. Gordon Russell, global head of risk at Broadridge Investment Management Solutions, a provider of investment management, reference data and risk technology solutions to more than 250 hedge funds and five of the top 10 fund administrators, explains how his clients are managing within the new regulatory environment in part by leveraging risk systems across multiple asset classes to identify more efficient trading solutions.
Hedge Funds Review: How can funds easily understand their risk exposures?
Gordon Russell: We firmly believe that the ability to access and visualise their risk is critical for funds today. In terms of investment decision-making, the environment we live in now is more ‘real time’ than it ever has been. Knowing the fund’s overall risk exposure is no longer an end-of-day process, and it is no longer a mid-morning process. It is a real-time process.
Hedge funds now expect to be able to see risk in real time and be able to manage and actively mitigate risk exposures in order to lock in as much alpha as possible.
Hedge Funds Review: Is real-time information really that important?
Gordon Russell: It is absolutely standard. As a systems vendor, if you can’t show hedge funds real-time risk management, then you’re not going to be able to persuade them you have a credible solution.
Hedge Funds Review: Does that mean you have to create a bespoke package for every hedge fund or can you provide more generic, off-the-shelf solutions?
Gordon Russell: In terms of solutions, on the generic side are asset classes, pricing and the ‘look and feel’ of the presentation of pricing and transparency. Those are standard issues – clients expect them. If you can’t show those elements on day one, then you won’t move to the next step with a fund.
What is absolutely important is flexibility. Traders tend to fundamentally believe the way they view their data and information gives them a market edge. This means that, even if people are sitting in the same office with the same data, they will have different views and therefore want a different cut of data and information.
Once you have the generic level package of tools and information, you also have to be able to give different individuals access to that information in a way that makes sense to their investment/trading processes.
Hedge Funds Review: What constitutes an effective risk management solution for hedge funds that trade across multiple asset classes and multiple jurisdictions?
Gordon Russell: The number-one requirement of an effective risk management solution for funds with multiple asset classes and jurisdictions is the ability to aggregate risk across asset classes and regions. That is imperative.
This happens to be an area in which we’ve had significant success over the past 12 months. Funds that are truly cross-asset and need the ability to aggregate risk have found that Broadridge’s systems meet some very challenging needs. Risk management at that level comes down to a number of areas: pricing; sensitivity analysis; scenario analysis; and the correlations around scenarios.
The fact is that risk can no longer be siloed. Funds can’t look at risk just by asset class. They need to look at risk in its entirety and to be aware of the correlation risk of their books.
Hedge Funds Review: Can you give us an example of this?
Gordon Russell: Certainly. If a fund’s equities are moving, what does that mean for its fixed-income book? A simple example would be if the share price for IBM is moving – up or down – how does that affect the bonds or any other derivative of that equity? Having the ability to aggregate and see risk across asset classes is hugely important.
Hedge Funds Review: Why is visualisation that important for hedge funds in monitoring risks?
Gordon Russell: Because hedge funds are in business to take risk, and they want and need the ability to manage those risks more efficiently, the visualisation of risk becomes crucial. Any risk decision they make is a conscious one and a financial one; therefore, they’re spending time and money on the visualisation component to get to that decision more quickly.
Looking at numbers in a spreadsheet versus looking at a picture or a graph is very different. Our clients are excited about the ability to visualise risk in a dynamic, pictorial way. They believe it will help them speed up their ability to make risk decisions, as well as manage tail risk.
If you can graph something and really visualise it in a 3-D chart or other representation, you can have a much better view of where you think the tail risk is and where you believe your business should be hedged.
Hedge Funds Review: What would you say are the top risk factors for funds trading multiple asset classes?
Gordon Russell: Number one, aggregate risk. Number two, real time. Combine these; you need to be able to aggregate risk in a real-time environment.
Factor number three is the ability to hedge the risk in a portfolio and mitigate that risk. For example, if I can see I have equity credit delta of x, if I now put on a hedge, how is that going to reduce my equity credit delta?
Historically, funds have had to essentially guess around the effectiveness of a hedge, but the effectiveness of hedges is hugely important because the cost of hedging the book today is, or can be, expensive. Traders need to ensure their hedges work.
In the list of factors, you’d probably want to also include flexibility on pricing. It is better to have both the market and model price and view them next to each other. Many hedge funds like this feature because it gives them an ability to take a directional view. For example, they can make a decision based on what a theoretical modelled cost would be, where the market cost actually is, and what could/should happen to that particular asset.
Hedge Funds Review: How can better risk systems effectively keep hedging costs down and not eat into alpha?
Gordon Russell: Let’s take a look at interest rate risk. A client will use a variety of short-term products to hedge that risk. They say, ‘I have these three or four possible instruments: which one of these is going to reduce my risk and be the most cost-effective?’ A manager should have the ability to pick and choose various hedges on the fly by dragging and dropping them into a portfolio. Then they run the portfolio again and weigh the effectiveness of each hedge on the trade. This will give them their answer.
Hedge funds will also decide to mitigate risk by creating bespoke products. With that approach, they want the ability to model the result within their own solution and derive a theoretical price. Then they can go to different counterparties and say: ‘This is what I am looking for – what price are you going to offer me?’
Having run the model, they can challenge the counterparties if the pricing looks wrong. ‘I’m looking at a theoretical price at x basis points and you’re telling me it’s going to cost x+50. Why would that be?’
That is something clients are very keen on. With the right information, a fund manager can make a conscious decision around why they are paying a certain price.
Certainly the clients that we deal with are already very smart about costs. Partly because many of them are from the sell side, so they’ve seen it from the other side of the trade. Before they buy an instrument, these clients want to be able to know the difference between a market model price and a market price, and determine whether that spread is fair.
Hedge Funds Review: What about counterparty risk of service providers? What kind of assurances do funds and their investors want when choosing service providers in the technology area?
Gordon Russell: Size does matter in this area. Broadridge has made investments in its business with industry experts, and also in leading-edge technology because we believed we could and should start working with even bigger organisations on the funds side – clients running tens of billions of dollars of assets. So we have added substantial heft to our risk offering through our Risk Master solution, and to service the expanding client base, we’ve also added additional sales and support staff globally.
The idea of vendor risk is where the Broadridge credibility comes through. Very large hedge funds and asset managers are keen to ensure any solution provides the stability and longevity they need when making such an investment. We achieve high levels of client satisfaction because we continue investing in our software and technology platform and providing an excellent level of service.
Hedge Funds Review: What can you do to help traders and hedge fund managers meet regulatory challenges and stay compliant?
Gordon Russell: Regulation is certainly something that many of our clients are concerned about. Regulators over the past few years have been very focused on ensuring there is legislation in place to reduce the possible impact of systemic fallout in the financial markets.
Although with hedge funds they have traditionally been very ‘light touch’, regulators are now asking many more questions. This has meant a different regulatory climate for funds that have launched within the past 12 months. At Broadridge, we’ve been helping start-up funds to understand the type of regulatory reporting that is required of them, and ensure they have a proper, scalable system in place so the available data and reports are already configured around the information that regulators need.
Hedge Funds Review: What about the differences between regulatory bodies and the challenges that creates?
Gordon Russell: There is always going to be a requirement for flexibility in a risk solution. In Asia there is a big difference between what the Hong Kong Monetary Authority and the Monetary Authority of Singapore want reported. While we offer an ‘out-of-the-box’ reporting functionality with a certain level of data enrichment, we also have to ensure it is flexible. A rigid reporting framework that is great for Hong Kong but no good for Singapore, London or New York, would not work in this business.
Hedge Funds Review: Are the challenges for older, established funds different?
Gordon Russell: We have found that it is a bigger challenge for established funds. For the newer funds, it has been easier because they’ve had to implement regulatory-compliant systems from day one.
Older funds have had a tougher time adjusting to the new regulatory environment and have had to deal with legacy systems not designed for current regulations. In the past, funds enjoyed light-touch regulation and, as a result, are not used to having to store the terabytes of data their funds produce. Many funds don’t have extensive time series information, risk reporting frameworks or other detailed information that they now need.
We have helped numerous firms with our reference data solutions by ensuring their data quality remains high. We then combine that data with our risk solutions to provide the reporting and risk framework needed to meet the regulatory requirements.
The key for success in this area is quality data, delivery of a high level of out-of-the-box functionality in terms of risk and calculation, and data reporting with a level of flexibility. This means, if a fund is domiciled in a number of jurisdictions, it can report risk in the way each regulator wants without having to rewrite or rethink its risk reporting framework.
Hedge Funds Review: How can you help funds keep on top of changes to regulation as well as the differences in reporting requirements?
Gordon Russell: Something to remember with hedge funds is that they are working with a number of counterparties. They’re working with business solution providers, fund administrators, prime brokers and the executing brokers that roll up into prime brokerage, as well as other functions.
When it comes to keeping on top of the regulation, the onus is on the fund to provide the correct level of reporting. Our job is to make it easy for them.
We do this in several ways. First, looking at European and US regulation, both sets of rules require a lot of data and, from a risk perspective, scenario analysis. We’ve created a framework around risk reporting so our hedge fund administrator clients can provide that reporting to their own fund clients who then provide it to regulators either directly or via third parties.
Alternatively, we work with hedge funds directly to build a customised framework around the data they need. When it comes to regulatory reporting, the format of each regulatory report filing and the data it requires is the most important thing. We are focused on providing the data that is required for each main jurisdiction, while building in flexibility around the level and granularity of the data as needed.
In terms of the format of the reporting, the onus is on the fund itself to be able to provide that, but our systems help them do that easily and flexibly enough to meet regulatory requirements from multiple jurisdictions.
Hedge Funds Review: Aside from investors, regulators are also keen for hedge funds to have strong providers and monitor those relationships. Has this been something you can help with?
Gordon Russell: We provide a certain level of counterparty risk reporting and analysis to the client. If a hedge fund has two prime brokers, they need to understand exactly what its basic counterparty risks are, and that’s a fairly sensible process.
But if we take it to the next level, which is the creditworthiness of counterparties and how their ratings affect the view on the relationship and the pricing of counterparty credit risk, we haven’t found there to be a great amount of interest yet. If they have a consolidated view of counterparty credit risk at a high level, most funds are fairly satisfied.
Hedge Funds Review: And, for the regulators, is this enough?
Gordon Russell: We’ve been providing high-level counterparty credit risk reporting to clients for some time. Now it is part of the reporting process for regulators as well. I think it’s going to be difficult for regulators to push hedge funds to go any deeper than that.
Hedge Funds Review: Finally, what are going to be the future challenges?
Gordon Russell: I think what is really going to change in the next three to five years is the amount of data needed to manage risk effectively.
Regulators are asking for more data in order to manage and map risk, and investors want the same thing. We’re talking about historical simulations and scenario analysis. The ability to access this data in a flexible manner and be able to report on it in as near real time as possible is here to stay.
Also, the complexity of the market is going to return. We’re already seeing new instruments coming into the marketplace that are hybrids of derivatives and need pricing. This will need to be managed.
From a risk point of view, we will need visibility into where the risk is in these new instruments. We will need to develop systems that are flexible enough to capture new instruments, price them and hedge them, then let everyone on the chain understand the liquidity risk impact of these instruments. As a solutions provider, we need to give fund managers the necessary tools that enable them to make conscious risk decisions.
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