The Science of Compliance

Life was relatively simple, the regulations in Europe were not overly complex (Undertakings for Collective Investments in Transferable Securities - UCITS I, being the pan EU regulation in force), the number of funds was manageable and their investment domain (Equities, Bonds, exchange traded derivatives) was straightforward.

Fast forward into the nineties and the increasing complexity of regulations, more demanding clients and the usage of exotic asset classes meant that a compliance officer had to rely more and more on IT support to maintain control. Excel sheets were created with esoteric macros to check the compliance rules. Some of the larger organisations even started to develop their own in-house bespoke systems.

Now, beam us forward to 2007 and the daily compliance burden has increased even further.

First of all, the regulatory landscape has been overhauled with UCITS III. The domain of Eligible Assets has been expanded, funds are able to copy known indices, the usage of derivatives is now not only allowed for hedging, but also for speculative purposes, risk ratios are required for the monitoring of sophisticated funds.

The ensuing expansion of the weapons arsenal of an asset manager combined with the clients’ hunger for alpha has driven managers to new investment products, such as Structured Products and especially to Credit Derivatives, e.g. Collateralised Debt Obligations (CDOs). These products are inherently more risky due to their complex and often multi-tiered composition. The fact that these instruments are dealt OTC means the ability to get reliable data about them is severely limited.

The regulatory landscape is still changing despite UCITS III being adopted as a standard across the EU as of February 2007. In 2004 the then European Commissioner for Internal Market & Services - Mr. Charlie McCreevy labelled the UCITS III framework as “a bit of an old banger”. Since that comment there have been various open hearings, market consultations, green papers, white papers and as of quite recently a directive which among other things clarifies further the assets which are considered eligible for a UCITS III fund. This piece of legislation will come in to effect in July 2008.

The complexity of all this is increased further for compliance departments who are responsible for funds which are domiciled in different countries. The Irish regulator’s interpretation of UCITS III is quite different to the German regulator’s. The EU states that a fund must be run through a risk management process. One country defines this to be Value at Risk (VaR) testing, another may require it to be full backtesting & stress tests. The national regulators issue guidance notes on a regular basis as do auditors who speak about “best practise”. This leaves compliance officers constantly monitoring the websites of the EU, CESR, National Regulators and Auditors for new information and thus taking vital time away from their daily operations.

Traditionally, compliance has been done on an Ex-Post (“after the fact”) basis, typically daily but sometimes either weekly or monthly. This is far too late when assets have been bought which are not allowed in the fund. The solution is obviously to move to an Ex-Ante mode (aka pre-trade) and to link up the Trade and Order Management System(s) of an asset manager to the compliance department. Portfolio managers are by and large not the most patient of people and therefore the main requirement here is to have real–time / near-time compliance checking. That means in seconds, not minutes. The implications here are huge, achieving STP and allowing trades to be sent for compliance checking can potentially save an asset manager large sums of money by preventing non-compliant trades.

Since UCITS III, there has also been the requirement for funds which use derivatives to monitor the VaR. This is not a simple calculation and means that a manager must have a risk management process in house, which is able to adequately capture all types of risks inherent in the instruments and strategies used.

What does it all mean for compliance monitoring?

It will become patently clear from the challenges mentioned above that a compliance officer is facing a tough challenge. So how can they make sure that they are doing all they can do to make sure their funds are compliant, that they are not entering into any unknown risks and that if there are breaches, that all is done to resolve them as soon and as efficiently as possible?

The first step is obviously the introduction of a robust and efficient system to enable compliance officers to conduct their checks on a daily basis, both on an Ex-Ante and Ex-Post basis. The system must automatically archive all check results and allow the officer to monitor the complete compliance lifecycle – detection, classification (active / passive), daily deterioration monitoring, investigation, reporting and resolution. It must provide full management statistics and give breach breakdowns by fund, fund type, fund manager and time period. Complex reports such as “Average time to resolution” must be available via scheduler or on demand.
The system must support the checking of hundreds of thousands rules - imagine a large fund administrator with 6000 funds and ca. 50 rules attached to each fund. The results of Ex-Ante checking must be made available instantaneously and must be also deliverable to any workstation in an organisation.

As we have seen, the compliance rules are constantly changing, therefore such a system must enable the compliance officer to create and modify the rule base. Ideally, a compliance officer should be able to subscribe to a codified version of the various regulations which are then updated automatically. These codified regulations must also allow for certain differing interpretations.

One of the largest challenges is the area of data provision. The regulations are becoming more data hungry and the relevant data, especially for OTCs, is hard to obtain. Therefore one of the most important features of a compliance solution is the ability to extract data out of multiple fund accounting systems, price feeds, reference databases, trade & order management systems, front-office systems and aggregate them in one consistent and structured compliance hub.

A compliance system must be able to look through complex derivative products, to be able to calculate the risk inherent in CDOs and other structured products. All this and the system must also be flexible enough to cope with new instruments and new data requirements.

What will the future bring?

By and large regulations become more complex over time, meaning that we are not going to see a UCITS IV which does away with all previous rules. Quite on the contrary the scope of regulation will more than likely be expanded and it is foreseeable that alternative investments (e.g. hedge funds) will be regulated in some shape or form, especially if we consider the spate of recent hedge fund failures.

We are likely to see the adoption of a more principles-based approach to compliance with the increasing usage of risk monitoring in the compliance process. For example why does UCITS III not allow a fund to invest 10.1% of its NAV in Microsoft, but allows the investing of 9.9% in a highly volatile emerging market equity? Indeed the divide between what is classified as compliance monitoring and what is risk monitoring will blur even further. We will hear more and more of so called “Chief Compliance Officers” (CCO) who will assume oversight also over risk monitoring.

Whatever happens, one thing is sure: the compliance officer will play an ever more important role in an organisation. Global Investor Magazine stated recently that “The compliance function has been elevated from its stuffy, paper-shuffling image and is now seen as a vital contributor to a company's bottom line. Top compliance officers have been pursued as keenly as star portfolio managers”. Indeed at the last Monaco Fund Forum, one person went so far as to openly declare CCOs to be “The new rock stars of the industry”.

It mightn’t be rocket science, but rather the science of compliance.

About Aquin

The Aquin Group (www.aquin.com) is one of Europe’s leading IT solution providers for the asset management and fund industry. Our goal is to provide solutions, which increase the efficiency and competitive position of our clients, enabling them to provide comprehensive client services and maintain prudent operational and regulatory controls.

Aquin’s reputation has been built on the combination of financial business knowledge, IT expertise and long term client relationships. In collaboration with its clients, Aquin has developed specialist investment software solutions for Investment Compliance, Order Management, Funds, Regulatory and Client Reporting as well as Custodian Reconciliation.

With MIG21, Aquin is the European market leader in investment compliance and risk monitoring. MIG21 optimizes Ex-Ante and Ex-Post checking and administration of legal, contractual and internal investment guidelines for asset management companies, advisors, custodians & insurance companies. With MIG21 LawCards® customers are always in full compliance with latest changes in the world's major investment jurisdictions including UCITS III and SEC 1940.

Aquin services a blue-chip client base including the world’s leading investment management companies including, among others, BNP Paribas, CACEIS Bank/Fastnet, Citigroup, Credit Suisse and Statestreet as well as five of the top six German asset managers, Deutsche Bank/DWS, Allianz Global Investors, Commerzbank/ComInvest, HVB/Pioneer Investments and Union Investment.

The company has its headquarters in Frankfurt am Main and subsidiaries in Zurich, Paris, Luxembourg, London, Dublin and New York.

Author: Andrew White, Aquin Components