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James Williams, Hedgeweek

US hedge funds take OTC clearing in their stride

By James Williams – “Even though as a quantitative trading firm with a lot of technology infrastructure in place we’ve been able to handle a lot of the regulatory requirements internally, we can’t do everything. We’ve had to lean a little more on our service providers, in particular consulting our legal advisers, over the last 12 months,” explains Ken Shoji, COO of New York-based GSB Podium Advisors, an equity statistical arbitrage fund.

Hedge fund managers face a delicate balancing act. On the one hand investors are increasingly looking to negotiate more favourable fees. On the other hand, the depth and breadth of regulation bearing down on managers has incrementally raised the costs of doing business. With their bottom line being squeezed it is little wonder that managers are pushing their fund administrators to develop cost-effective solutions; both to meet regulatory compliance needs and satisfy demanding institutional investors.

Hedge fund administrator Custom House Group has responded by developing Custom House Gateway, a technology platform that gives managers and investors a single point of access to the majority of middle- and back-office reporting needs. The fact that it also offers connectivity to an Order Management System means that trade data can be captured before execution to assist in the valuation process.

“Every day, the system pulls in trade information from various brokers and custodians and allows that information to be passed on and reported in an interactive dashboard,” explains Scott Price, Regional Director, Americas, Custom House Global Fund Services, confirming that the first version of Gateway is being released this September.

As well as providing core services such as NAV and daily portfolio reporting, Gateway will, over time, offer a range of regulatory reporting needs.

“The third release of Gateway will feature a whole range of compliance reports. When a client clicks on the compliance tab they will be able to drill down to the requisite regulatory report, input the range of data they are looking to populate the report with, and generate the report themselves. That applies to Form PF, quarterly reports to the NFA and investor reports,” says Price.

Jack Seibald is one of the principals of prime brokerage firm, Concept Capital. He concedes that the increase in global regulation has made it more operationally challenging for hedge fund managers, and, indeed, for primes to maintain the same high-quality service levels.

“Global regulation has created a mandate for our clients to develop, implement and maintain what we call “regulatory enterprise risk management” systems.

“At Concept Capital we have needed to closely follow the regulatory developments and ensure that we had the requisite knowledge base and expertise to continue to serve our clients as they face these new challenges. This has included retaining new personnel and identifying the best practice technological platforms available for our clients.”

Last year, a lot of managers tried to develop in-house solutions for Form PF or paid a lot of money to outsource it to consultant groups, according to Ted Jasinski, General Manager of Admiral Administration, the alternative fund administration arm of Maitland.

“We saw it was a complete headache for managers who went down the in-house route. We waited a while before launching our solution for a handful of our managers. We partnered with a group called Data Agent and really hit it out of the park. We were able to price it extremely well.”

One question that continually crops up in discussing regulation, particularly Form PF, is quite what the SEC plans to do with all this data. Transparency is undoubtedly a positive development, but knowing how to capitalise on terrabytes of fund data and prevent systemic risk is like trying to find a needle in a haystack.

“I heard anecdotally from one of the CFTC commission members that even based on the information that they have requested and are starting to receive they probably wouldn’t have spotted the London Whale event last year. That’s an indication that as these regulatory bodies look at all this data and use the transparency on offer, new standards will emerge which we’ll have to adapt to,” comments Jon Anderson, global head of valuations and OTC derivatives at SS&C GlobeOp.

Rather than be overawed, Jasinksi welcomes regulation because fund management groups “will become more dependent on the administrator to come up with the right solutions. We enjoy that challenge because we want to do more and offer full front- to back-end operational support. It’s what’s expected of us today.”

Aside from US regulation, managers must now start to seriously perform cost benefit analysis to decide whether to become compliant with the AIFM Directive. This is not an immediate concern as non-EU managers can still pursue private placement until 2015 and in Shoji’s view, the AIFMD is still at the back of most people’s minds:

“I’d say that most managers I talk to in the US are, quite honestly, underprepared and in some cases perhaps not as well informed as they should be about the requirements of AIFMD.

“Many service providers have done a reasonably good job of putting on seminars, publishing papers and educating the manager community about what this all involves. However, I think it’s going to come as a shock to many managers when they realise that if they have been marketing into Europe or have investors in Europe, they are going to be subject to a whole series of requirements such as disclosure of information on compensation.”

GSB Podium Advisors was founded in 2010 by Shengbei Guo who had previously spun out of Deutsche Bank’s prop desk to run the Deutsche Bank Noetic Equity Long/Short fund back in 2005. Aside from the Cayman-based fund – GSB Podium Statistical Arbitrage Fund – the firm runs a series of managed accounts, not to mention a UCITS version of the strategy.

The net result here is that if management firms like GSB also move to become AIFMD-compliant, they face the prospect of adhering to three different levels of regulatory reporting.

“Exactly. That’s the situation we’re in. Our UCITS fund allows us to market it across Europe and the rest of the world. If we wanted to market the offshore hedge fund, we would have to go through the AIFMD registration process,” says Shoji.

Right now though, the firm is happy to use the UCITS passporting opportunity and refrain from becoming AIFMD-compliant.

“Having said that, we happen to be in a peer group – market neutral statistical arbitrage – where there are not a lot of funds in the UCITS format so we do continue to receive reverse enquiries from all over Europe. But at some point we can’t just rely on reverse enquiry if we want to seed new investment vehicles. We do recognise that at some point in the next 12 to 18 months we’re going to have to think about registering under the Directive. And that’s a significant financial burden for a smaller manager like us.”

SS&C GlobeOp views regulation as a global issue. Anderson says that there will inevitably be some degree of overlap between Form PF and the AIFMD because a lot of the reported data is the same. He points out that most of its US managers have global clients and therefore cannot avoid European regulation.

“The fact is regulators on both sides of the pond are reaching pretty broadly. There has been some degree of rationalisation at least expressed by regulators saying that ‘equivalent’ regulation can satisfy all. You can’t segregate trades by nationality any more, it just doesn’t work.”

Given its expertise in technology, SS&C GlobeOp has been well placed to deal with the technology challenges, especially those related to CFTC clearing rules for OTC derivatives under Dodd-Frank. This initiative to bring the OTC market out from the shadows into something more akin to the futures markets – which incidentally created none of the problems in the financial crisis – is a huge endeavour.

Anderson confirms that there’s been a lot of development work over the last 12 months and this will continue “as parts of the regulation haven’t been clarified yet”. Major swap participants were required to start clearing OTC trades this March, with the second category of swap participants, including hedge funds, commencing this June, since when Anderson says the volume of OTC cleared has really expanded.

“We’ve had to go through system by system assessing all our middle office processes and enhancing them; we’ve had to enhance our collateral management system, our trade matching systems, etc.

“We think the number of collateral calls could potentially quadruple so from a volume perspective we’ve had to make sure our solution is scalable. I would say the biggest teething problem has been on information exchange protocols. Whether it’s finding out how exactly you’re going to exchange information with FCMs, or with market intermediaries like MarkitServ,” says Anderson, adding:

“A lot of FCMs in the initial phase of clearing were utilising their futures management systems. For some clients, in order to get all the data we needed to reconcile the trades we were getting five separate reports. We were able to rectify that; within two months every major dealer was sending us one report.”

Lisa Kennedy is Operations Manager at Pine River Capital Management, one of last year’s most profitable US hedge funds; according to Bloomberg the Pine River Fixed Income fund managed by Steve Kuhn was the 2nd best fund, returning 32.9 per cent. Kennedy says that whilst getting operationally ready to clear its OTC swaps was a complex process “with the support we received from our FCMs, middleware providers and the clearing houses it went fairly smoothly.

“Clearing before the deadline helped, as any little bumps were worked out quickly and without the stress of being mandated to clear. In honesty, we anticipated more bumps – especially in the beginning – but I can’t say there was anything specific that really caused us a lot of pain.”

Taking a proactive stance in getting ready ahead of the June deadline served Pine River well.

“There were a lot of starts and stops along the road to mandatory clearing. We’re pleased that we’ve passed that milestone, and now we can focus on the next iterations of reform. Things continue to evolve, with SEFs slated to come on board by the end of the year, new clearable products being introduced, EMIR Protocol, etc. We are devoting significant staff and time to assure we stay on top of everything.

“There are still regulatory decisions being made/finalised that will affect the future so I think a year from now it might be a more interesting story. Right now things are still evolving,” states Kennedy.

The operational impact on GSB Podium Advisors has not been too great because they are less active in swap trading than other major hedge funds like Pine River. Shoji confirms that on a day-to-day basis the move towards OTC clearing hasn’t had any meaningful impact: “It’s not going to change the way we trade. Having said that, we’ve become a lot more sensitive over the last couple of years about the friction costs that all of these changes impose on our strategy.”

One of the biggest challenges to OTC clearing is the complex margining and eligible collateral rules that participants will now face. Hedge funders are well used to the process of posting margin and leaving unencumbered assets with their primes and seem to be taking the CFTC’s new rules in their stride. They are used to operating on a highly collateralised basis and moving funds on a T+1 timeframe.

For other more traditional participants who use derivatives to hedge their portfolios, however, the need to deal with potential intraday margin calls represents not only an operational challenge, but a behavioural challenge too.

Piers Murray is global head of Fixed Income Prime Brokerage at Deutsche Bank and runs the OTC clearing business. He says that clients who are most affected are the large institutional asset managers who’ve never had to post collateral before, “or when they have they’ve only had to post variation margin with a high threshold. Also, they’ve never had to post collateral with the speed (T+1) that is now required by CCPs. So the largest behavioural change is being felt in that group.

“Then you have the insurance companies who invest in long-term assets and use derivatives as an overlay to hedge against rates movement. Such derivative trades could stay on the books for a very long time. These clients now have to post cash variation margin against their hedges as well as initial margin. Previously, they could post variation margin in the form of bonds that they had on their balance sheet.

“Now that the variation margin has to be paid in cash, how does a pension fund transform its bond holdings into cash without going through some kind of repo or collateral transformation structure?” says Murray.

The final rules on the cost and eligibility of collateral posted to the CCPs are yet to be fully determined but it’s clear that the wider institutional firms, less so than trade-oriented hedge funds, have a lot to get their heads around. At the end of the day, CCPs need to control their risks to the clearing member, while the clearing member itself is under mandate from the SEC to put defined trade limits (below which margin calls are made), in place with their clients.

The added transparency of moving away from bilateral OTC trades is a good thing. But the controls and procedures that need to be put in place, for all participants, has, seemingly overnight, created a spider’s web of interconnected relationships between the CCPs, clearing members, and clients.

Summing up his thoughts on regulation, and the increased focus on filings, Shoji observes that whilst there might be in excess of 8,000 hedge funds, only 200 to 300 really matter (from a systemic risk perspective) in terms of their size:

“I think the systemic risks posed by the hedge fund industry are maybe overstated. Whether the introduction of all this market regulation over the last few years has helped reduce systemic risk is still, in my view, very much open to debate.”

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