Get the risks right
Tony Freeman (pictured right) addresses the increasing importance of operational issues for asset managers
The front office will always move at a faster pace than the middle and back office, and the industry understands this. We have however now moved into dangerous territory because the gap between the two areas has been allowed to expand and investment in the post-execution environment has been neglected.
Hedge funds and asset managers have wanted to widen their scope and capacity to trade options and derivatives as well as cash, and to do this the buy-side has had become increasingly aware of risk and transparency issues, and the technology necessary to achieve high standards in these.
Last year’s events serve as a reminder that the industry has traditionally underinvested in risk management. Prior to the downfall of Lehman Brothers and Bear Stearns, nobody questioned the viability of counterparties, but in this new environment, audit trails and transparency in trading activities are paramount.
Operational efficiency and technology capability have become important issues, and the regulatory focus on the global perspective will be on transparency.
Much as we do not often think about car insurance until after an accident, many of those individuals outside the operations function had not given sufficient thought to mitigating operational risk until we found ourselves in this wreck. Operations and the risks inherent in its processes, it would seem, were considered to be separate, something only for the folks in the middle and back office to concern themselves with.
With current levels of volatility, there has been a significant increase in trading volumes, which drives the need for best-of-breed processes within a firm’s operational infrastructure. Manual processes like faxes and spreadsheets are never sustainable, but this is particularly pertinent when heavy volatility leads to massive volumes of trades that need to be processed.
Risk will be a primary metric going forward; banks, brokers, traditional and hedge fund managers will all focus more than ever on mitigating, measuring and managing risk. To handle this, investments will need to be made in new staff and systems, not in the old proprietary infrastructures that led to the problem. The emphasis will be on smart spending on industry-wide, common processes, as market conditions will continue driving cost reductions across the industry.
It would seem that when it comes to many of the ‘basics’ of operations (as with equities and fixed income), the industry seems to understand the correlation between automation and reduced risk.
Hedge funds, one of the major investors in exotic instruments, have played a significant role in raising the importance of the back office as greater automation is required to support the creation of new strategies and increased complexity in the front office activity. No matter how risky an investment strategy may be in the front office, once a trade is executed, there is a vested interest for everyone involved in that trade across its lifecycle to ensure that operational risk is mitigated to the greatest degree possible.
The risks inherent in the back office are no longer acceptable as a given cost-centre of the business. Instead, from the back-office to the boardroom, firms are beginning to look to solutions that mitigate the risk of operations to ensure cost savings, efficient business and overall peace of mind. This is particularly true as the industry recognises the need for common, transparent efficiency and process from firm to firm, and will likely be the approach regulators will look to as they seek greater transparency at the industry layer.
There is no doubt that the advent of OTC derivatives and the hedge fund industry’s voracious appetite for exotic instruments has led to significant strides in the technology the buy-side uses, and with institutional investors increasing their asset allocation to hedge funds, trade processing and infrastructure capabilities have become a key competitive differentiator when vying for investor funds.
The ability of the investment manager and broker/dealer to match the details of a trade on the day it is executed will often enable faster, less error-prone settlement, and will go a long way towards eliminating risk from the whole process.
Earlier this year, Omgeo commissioned a study from Oxera Research, which examined the prevalence of same-day affirmation in Europe and highlighted some interesting points around automation.
Automated same day affirmation (SDA) processes lead to reduced operational risk and improved settlement: settlement failure rates for clients with automated trade verification processes can be as much as 50% lower than for non-automated clients. The findings of the report suggested a direct correlation between SDA and reduced trade fails as well as the mitigation of costs associated with rectifying these fails. These costs included the various risk exposures (such as position risk), the increased funding requirements that come with greater uncertainty in the settlement process, and claims, penalties or other direct costs associated with trades that settle either late or not at all. Operating costs are reduced through automated SDA: automation enables a larger volume of trades to be processed without a corresponding increase in costs and risk, therefore allowing firms to maintain the same level of staffing in the middle office irrespective of trade volumes. In addition, automation reduces the rate of failed trades, which means fewer costs downstream in record-keeping, reconciliations of settlement instructions, corporate actions, claims handling and other functions required to resolve failed trades. Using manual processes in the trade lifecycle such as phones and fax can mean that trades are not being affirmed at all: in some instances, settlement instructions are being sent by the broker/dealer to the custodian bank without explicit affirmation by the investment manager. So, if there is a problem with the trade, it needs to be resolved by the custodian - a costly and inefficient process. Efficiency gains from adopting automated SDA translate into lower transaction costs for end-investors: reducing risk and costs borne by investment managers, broker/dealers and custodians in the trade verification process can also translate into lower costs for end-investors - in a competitive industry, reductions in the risks and costs borne by internet managers and broker/dealers (or other intermediaries and infrastructure providers) would, once these benefits have been realised by a significant part of the market, be reflected in lower prices, resulting in lower transaction costs for end-investors and producing associated beneficial effects on liquidity.
Current market conditions, as well as investor and regulatory backlash, are placing more importance on transparency, requiring buy-side players to disclose more information about positions, risk management and operations to their investors.
That means both rationalising unnecessary technology and investing in technology to improve operational efficiency. Manual processes should be eliminated wherever possible, across the entire trade lifecycle. Phoning, e-mailing or faxing trade confirmations, re-keying trades into multiple systems, and using spreadsheets as ‘workarounds’ to fill in technology gaps, common practices in many firms, must be eliminated.