Navigating unchartered waters: The regulatory tide turns for Hedge Funds

Investment Technology

Navigating unchartered waters: The regulatory tide turns for Hedge Funds

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Michael Cummins, Portfolio Management Lead, FINBOURNE Technology

2021 marked a strong and eventful year for global hedge funds, with total invested capital rising from $3.58 trillion in 2020, to an unprecedented $4.04 trillion by December 2021[1]. With the pandemic-induced volatility playing well to actively-managed strategies, including those of long/short equity shops, hedge funds have piqued interest from institutional investors – as they reallocate and diversify away from low-interest bonds and balance passive investments, such as ETFs and indexing strategies.

With a shaky and uncertain start to 2022, there has been no shortage of volatility, with the war in Ukraine, soaring energy prices, and the crash of the Chinese economy, all pushing the VIX up 63% YTD at 26.99 (as of the time of publishing). Given this, the road ahead for hedge funds is promising, particularly with the well-timed exploration of ESG investment strategies, tokenisation and other digital assets. In fact, according to the leading alternative investment industry body, AIMA, this ‘renaissance’ could result in further industry growth – reaching $5 trillion AUM in the next 12-18 months[2].

However, the scale of global assets under management has not gone unnoticed and regulation is set to play an equally major role in the hedge fund industry this year. In the EU, there are reviews expected across the Alternative Investment Fund Managers Directive (AIFMD), the European Market Infrastructure Regulations (MiFIR) frameworks, and the EU Short Selling Regulation. While, across the pond the U.S Securities & Exchange Commission (SEC) has firmly set its sights on hedge funds, with the goal of improving market transparency. Where the EU and SEC lead, APAC regulators will surely follow, making this a likely eventuality for funds across the globe.

In their press release earlier this year[3], the SEC stated the proposed disclosure rules will ‘enhance the Financial Stability Oversight Council’s (FSOC) ability to assess systemic risk, as well as, to bolster the Commission’s regulatory oversight of private fund advisers and its investor protection efforts.’ The view is that reporting will provide greater visibility of hedge fund activity, which could in turn offer timely market stress signals. In theory, the commission is seeking to mitigate potential crises or events, such as the Archegos collapse in 2021 – erasing billions of dollars in losses at three of the world’s largest investment banks.

The question is, how will these regulations impact hedge funds across the globe and how will fund managers continue to secure capital allocations and respond to market opportunities, while sailing in unchartered waters?  

Systemic risk prevention or more red tape?

While hedge funds have enjoyed a lighter touch approach, compared to their asset management counterparts, the new wave of SEC disclosure rules and indeed the AIFMD and MiFIR revisions expected in Europe, will see hedge funds bracing themselves against a changing tide. Having ‘identified significant information gaps’ over a decade’s worth of data, the SEC is intensifying its focus, starting with larger funds of $2+ billion AUM, before dropping down to include funds of $1.5 billion AUM.

For now smaller funds can breathe a sigh of relief in the short-term, but they should not consider themselves completely unscathed. History has taught us that such regulations will likely continue to decrease in threshold over time, in order to capture a larger share of the market. Paying attention and readying the ship for stormy waters now, will pay dividends in the long-term.

The SEC’s initial proposal pushes the envelope further than ever, requiring hedge funds to report in several instances; from when a fund is terminated, to events where it experiences a 20% drop in net asset value over 10 days, a 20% increase in margin requirements over 10 days, an inability to meet collateral calls, and any redemption calls that exceed 50% of the funds value. To do this, hedge funds will need to have their investment data readily available and at little to no notice, while firefighting one or more of these events.

The thinking is that these events may correlate across a number of funds, which would then pose a secondary threat in other parts of the capital markets. If we look back, there is some evidence to suggest hedge fund blowbacks have played a role in past market events. This includes the recent 2020 US treasury market crash, where the hedging of treasury bonds and futures, contributed to a $90bn loss in the market and caused a rather sticky and illiquid moment in US history.

Considering the new disclosure rules are the strongest since the Dodd Frank act, it is unsurprising that they have gone down like a lead balloon among fund managers. Many hedge funds and  industry groups, including the American Investment Council are hitting back at the proposals, suggesting they are simply an exercise in ‘taming the beast’. While others question whether further transparency would really limit systemic risk – arguing that they only serve to add ‘unnecessary paperwork’ and according to some, more ‘red tape’[4].  

Perhaps this is why SEC Commissioner Hester Peirce, delivered the only vote against the new rules. In her statement, Peirce questioned whether it was ‘appropriate or even wise’ for the SEC to be demanding information within one business day when a ‘hedge fund is suffering losses equal to or greater than 20% of its net asset value over the course of 10 days’.

Here is where the problem lies…The trouble isn’t just with the reporting itself, it is the T+1 timeframe, which the SEC is demanding, that is causing concern among funds. To meet this, funds will need to arm themselves with a wealth of data available at the push of a button – requiring not only a well-oiled data infrastructure but a comprehensive Portfolio Management System (PMS) that can monitor the fund in real-time and generate reproducible numbers for reporting.  

While, there are some frontrunners, including giants such as Blackstone, who are unsurprisingly ahead of the curve with both regulatory and investor disclosure, for the majority of hedge funds, meeting this regulatory mandate, with poor systems and data processes is going to be a challenge at best, and impossible at worst. Considering these rules form part of the SEC’s ambitious plans for policy reforms on issues ranging from ESG, to cybersecurity – this may well be the tip of the iceberg.

SaaS technology and the regulatory response  

Amid the pandemic, cases like Archegos and others before it, hedge funds are recognising the need for automation and efficiency in their operations. While there is still some way to go, the new rules may accelerate the urgency, acting as a litmus test of the many issues that lie beneath the surface. To steer the ship, funds will need to address not only core data processes, but cost optimisation and efficiency gains, if they are to succeed in meeting the regulatory wave headed their way and keep a sharp focus on the horizon.

Technology investment forms a critical tool in achieving this, enabling a timely regulatory response and delivering against AUM growth. While, running a hedge fund efficiently requires an initial investment in technology, maintaining that investment is just as important if not more significant, to the prosperity of the fund. Data management plays a vital role here, because data itself is a vital asset to mission-critical workflows, including reporting.

To date, with a relatively relaxed regulatory backdrop, larger hedge funds have channelled most of their efforts on alpha generation and strategy implementation. But as they have matured, their technology investment has lagged over time, leaving funds with an accumulation of ‘technical debt’. This means more systems to rip out or integrate to, and more data to migrate and feed into. Combined with increased regulatory scrutiny, this tangle of outdated systems has created a number of operational barriers, making it difficult to meet regulatory change management within the required timeframe.

In our recent hedge fund market report, we identified that many of the challenges and opportunities funds are facing, including those around regulatory requirements and investor due diligence, can be addressed by Software as a Service (SaaS) technology, which tackles the root cause of inadequate operations. For smaller, leaner funds, the inevitable future provides a timely opportunity to secure a scalable data foundation sooner rather than later, to support and future-proof PMS capabilities, while providing the ability to adapt to incoming regulatory and market changes. The trick for emerging funds will be doing this at lower cost, with greater operational ease and without taking their eye off the ball.

In the past, hedge funds have been limited to either buying and outsourcing solutions, or building technologies to serve their operations. Now, with the convergence of market complexity and increasing data requirements, ownership of investment data is proving critical. This doesn’t necessitate building your own systems though – there is another way. Emerging technologies, such as cloud-native, SaaS solutions can reduce operational effort and increase agility.

These interoperable solutions empower funds to choose what services to buy, build, or connect with, to achieve efficiency across workflows – it is no longer an either/or decision. When combined with PMS capabilities, a SaaS data management platform enables both greener and more established funds with a cost-effective and responsive foundation to support data-intensive workflows; from portfolio management through to investor reporting and accounting.

With one source of real-time data serving operational, investor and regulatory needs, funds can holistically benefit from a system that delivers transparent oversight, enhanced control and innate financial sense. SaaS technologies also make it easier to operate in a proliferated data environment and excel at translating large volumes of complex, multi-asset data, including alternative asset classes and newer asset classes, such as cryptocurrency.

Additionally, an extensible data model enables funds to consolidate these disparate sources and formats of multi-asset data in one data store, providing CFO’s with timely and trusted data and a real-time picture of their Net Asset Value (NAV).

The benefits also extends beyond the fund itself. The use of open APIs simplifies connectivity and unlocks data from other systems, providing a complete audit trail for data interrogation. Using a secure cloud infrastructure, this data can be permissioned into the extended ecosystem, automating the delivery of stakeholder- specific information to regulators and investors, within a T+1 timeframe.

Importantly, SaaS technologies also deliver advanced features such as native bitemporality,  generating reproducible data – a significant factor for both operational and regulatory reporting. With an immutable event register – a ledger of all changes or events, which have happened to a portfolio and related entities in the system, funds can leverage a fully indisputable Investment Book of Record (IBOR), enabling data to be reproduced as it was, at any point in the past.

Future-proofing AUM growth

By adopting an interoperable approach to hedge fund operations, rather than the black and white confines operated in till now, funds can de-risk operational change and ensure business continuity in an increasingly regulated market, all while achieving a scalable and resilient platform.

Without addressing technology investment and unlocking data potential now, navigating through an evolving regulatory storm will be testing. Only by improving operational infrastructure and data processes, will hedge funds mitigate regulatory cost and operational risk. At the same time, industry standard connectivity future-proofs the fund, with access to the latest innovations in the market, helping to accomplish competitive edge in a crowded market.

More than anything, real-time access and control of data breaks down the complexity experienced by larger funds and that yet to come for smaller funds, so that they can confidently meet regulatory and investor demands, while securing the allocations that will their fuel growth. In the end, it is technology, along with people and processes that will sustain the bottom line.

About Michael Cummins

Having spent the last five years leading consulting and onboarding engagements for hedge fund clients at Enfusion and supporting hedge fund operations at State Street, Michael Cummins has acquired a deep understanding of hedge funds and the market challenges funds operate in. In his role as Portfolio Management Lead, Michael is part of the delivery team for LUSID PMS, FINBOURNE’s recently launched next generation PMS solution, designed to empower hedge funds.

[1] Hedge Fund Research, Nov 2021

[2] What’s in store for the hedge fund industry in 2022?, Tom Kehoe, MD, Global Head of Research and Communications, AIMA, Dec 2021

[3] SEC Proposes Amendments to Enhance Private Fund Reporting, Jan 2022

[4] Private equity and hedge funds pan SEC’s push for more data disclosure, Pitchbook, Jan 2022

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