Automatic gear shift

Supply and demand for technological solutions are both on the rise–and necessarily so. By Lord Calum Graham, Advent Software EMEA

For the global hedge fund industry, 2005 was something of a rollercoaster year.

Heavy losses in the Spring and a torrid October saw a return of some of the old reputational and performance spectres that haunted the industry in days gone by, made all the more frightening by the skeletons unearthed at a number of well-known, high-profile firms.

The resulting market jitters saw several institutional investors rethinking their allocation to the sector, while an array of smaller funds had to close their doors in the face of weak investor demand.

In spite of the earlier gloomy prognostications, the year ended with a return to form with strong results in November and December pulling many of the indices back towards the double digit realm for the year.

Meanwhile, assets continue to grow as pension funds and other institutions channel money into the industry, albeit at a slower pace than previously.

ADDED REQUIREMENTS

Yet despite the bounce back and the collective sighs of relief, the coming year will be far from a return to business as usual. New compliance requirements, introduced as of February by the SEC, are now a feature for any hedge fund advisors with a roster of US clients, while regulators in the UK, the Netherlands and Japan are keeping a close eye on the sector’s development in their respective markets, with more monitoring and reporting potentially to follow.

Then there are the industry pledges made in September – and stepped up in December – to improve transaction processing of credit derivatives. While it is the 14 major dealers specifically that have committed themselves to reduce the confirmation backlog and eventually move the industry to a T+5 standard for vanilla confirmations, achieving the targets means the dealers’ hedge fund clients will also be forced to play their part; at a minimum, that means adherence to the International Swaps and Derivatives Association’s Novation Protocol plus use of the Depository Trust & Clearing Corporation’s Deriv/SERV electronic matching platform.

And the changes will not just affect market players in the US. The UK’s FSA has been bearing down on this issue since last February, and it, together with Germany’s BaFin and the Swiss Federal Banking Commission were parties to the September commitments, ensuring improvements will have to be made in their jurisdictions likewise.

More generally, the shift in make-up of the industry’s client base is changing the type and level of services hedge fund managers will be expected to provide.

With a greater proportion of institutional money flowing into the sector, hedge funds are facing demands for more frequent and higher-quality reporting, greater transparency and improved risk measures, while burgeoning retail sales bring all the above plus a brighter regulatory spotlight.

CORE ELEMENTS

Thriving in this evolving environment then will depend on three core elements: a sound trading strategy, the ability to attract and maintain capital, and – and here is where the paradigm is really changing – a robust, efficient technology environment.

A few PhDs and a bucketful of money just won’t cut the mustard by themselves anymore. Rather, tomorrow’s success stories will need an IT infrastructure that can keep pace with ever-more complex instruments and trading strategies, as well as meet their compliance needs and investors’ demands for quality service.

In this situation, automation will be crucial at each stage of the transaction lifecycle, whether it is capturing market data the millisecond it arrives, feeding algorithmic trading engines, generating risk and portfolio analytics, settling trades, valuing portfolios or producing reports for clients and regulators.

Every place where there is a technology short-fall, each chink in the chain, raises the prospect of a missed or underutilised trading opportunity, exposure to default, an erroneous corporate action or a compliance oversight, or the more malignant prospect of a disgruntled client.

You only have to look at the credit derivatives confirmation mountain to see the sorts of risks that can arise in the absence of automation.

Less dramatic, but no less crucially, automation provides a platform from which hedge funds can decouple their business growth from their staffing needs.

Competition in the industry is only going to become more intense, so piling on the staff to cope with every hike in assets under management just won’t be a feasible operational escape clause in the future.

TACKLING TECHNOLOGY

So how can firms tackle this technology quandary? Various options are available. Outsourcing is one well-worn route. Traditionally, prime brokers and third-party administrators have offered a panoply of support functions to their hedge fund clients. Now, however, pushed by competitive pressures from their peers and client demands, these providers are having to broaden the suite of services they provide, and enhance the technology solutions they make available to their clients.

To a greater or lesser degree, funds can also opt to develop their facilities in-house. While there are advantages from having a bespoke infrastructure, the cost of development and maintenance will prove prohibitive for all but the very largest managers.

Even Citadel Investment Group, a $12bn Chicago-based fund well-known for its heavy proprietary technology investment, recently cut a large chunk of its IT department after deciding to out-source data management to Accenture. We can expect to see more of the same in the future.

The third option is to make use of vendor systems and packages that are coming to market. In the past, that has not always been possible.

Although there is considerable choice when it comes to available third-party technology, for the most part the alternative investments arena has had to rely on proprietary products to deal with the complexity of many over-the-counter trans-actions.

That situation is now changing. While technology development will always be a half-step behind instrument and trading-strategy innovations, some vendors are now rushing to meet the surge in demand from hedge funds and those traditional asset managers keen to increase their exposure to alternatives.

Of course, the best fit strategy will vary from firm to firm. Whatever the combination of solutions chosen though, what matters is that funds do choose. In this technology-dependent world, there is no option but to automate.