COMMENTAR Y


Moving Risk to the Front Office Better tools for more complex environments


BEN CHESIR, HEAD OF PRODUCT MANAGEMENT and BRANDEN JONES, GLOBAL HEAD OF MARKETING, LIQUID HOLDINGS GROUP


I. Risk in the new fund reality Both past and current decades remain marked by consistent uncertainty, as crisis after crisis has systemically rocked the financial markets. While these events drastically affected performance, regardless of asset class, the ripples of unforeseen exposures, shaky positions, and unmitigated risks continue to impact investors. On the buy side, risk management was traditionally relegated to the middle or back office – analyzed between the closing and opening bell. Risk was a night-time operation – an afterthought – post-trading, post-execution, and secondary to performance.


But emphasis on risk is changing, and growing. More and more, hedge funds are moving risk functions from a secondary process into the front office, proactively monitoring exposures in sync with trading and portfolio management functions. Greater risk emphasis is now placing funds in a better position to adjust strategies in real time and ultimately take advantage of trading and hedging opportunities over shorter horizons, all while simultaneously addressing transparency concerns for investors.


II. The risk hurdles This shift in risk has myriad challenges: • Transparency with investors; • Potentially unforeseen costs; • System completeness and reaction times; • Breakdowns in process.


Risk management and the ability to achieve the desired levels of transparency continue to be very difficult for hedge funds of all sizes. According to an Aite study, this in part is a result of hedge fund managers placing guards around their investment strategy and approach for years to protect intellectual property, key algorithms, and other competitive components.1 However, as investors now require transparency, improved data mining, analysis, and ongoing communications, hedge fund managers must reassess their tactics for making investment decisions. Achieving this new level of transparency requires sophisticated risk management controls vis- à-vis pre-trade compliance and post-trade analytics.


However, these controls and analytics have historically come at a steep price – a cost often prohibitive for a manager in the early days and months of operating. Citi Prime Finance’s latest hedge fund business expense survey reported that risk analytics, on average, cost $150,000 annually for a hedge fund with $100 million in assets – a cost that does not include the internal resources and back- office processes required to maintain and operate daily analytics.2 Beyond cost, there are additional hurdles for fund managers. Simply being live on a risk platform does not guarantee adequate or timely processing.


66


Fig.1 Frequency of risk information by hedge funds to investors (How frequently did/do/will hedge funds disclose risk information to investors – five years ago, today, and five years from now)


Source: BNY Mellon: Risk Roadmap, August 2012 5 YEARS AGO


38%


9% 3%


6% 6% 50% 16%


After a custodian or clearing broker’s nightly processing routine, data sets are typically pushed to secure FTP sites to create beginning- or end-of-day portfolio data sets. These data sets may be updated intermittently through the course of the trading day (intermittent or batched uploads carry an implicit delay in portfolio discovery and risk analysis). If the main source of position and trade data is a broker’s books and record system, the fund manager’s risk platform must capture and aggregate trades from different execution and order management systems, executing brokers, sales desks, exchanges, and swap execution facilities to be truly ‘position-aware’.


A position-aware system takes into account broker feeds and updates, which are typically limited to trades executed or cleared by that broker. A fund using multiple primes or executing brokerages will need to aggregate data from all points of execution, matching and clearing.


Breakdowns in data feeds, errors, and latency are all events that can place portfolio activities in jeopardy. Systems that use a “delete and load” paradigm each day add single points of failure, latency, dependencies and costs and can challenge historical portfolio replication capabilities. And ultimately, fund managers are at the mercy of third-party systems that cannot adequately track and record all intra- day activities in real time, thus exposing positions to significant risk in the immediate term, and over longer periods.


When the risk platform is intra-day, batch-scheduled, or T+1, these exposures and limits are more difficult to set, track and control, especially in highly volatile markets. However, once a manager has configured risk tolerances and limits at the trader, portfolio or account level, the focus shifts to monitoring and ensuring all trading activity stays within those risk tolerances and limits.


22% Daily TODAY 72% 9% Weekly Monthly Less frequently than monthly 5 YEARS FROM NOW 50%


19%


Risk, right side up Funds must sharpen their risk management and optimisation capabilities to accurately understand underlying drivers of risk, and balance the risk and return equation for different investors.3 In order to identify opportunities, managers need a risk platform that ensures accurate valuations at all points in the trade lifecycle. While many platforms do this post-trading-day activity, the right risk platform should simultaneously identify risk, and through proper controls, address constantly changing market dynamics, correlations, volatility, and market microstructures in real time to tackle live market prices and valuations. For emerging managers, market and liquidity risk capabilities are must-haves. Established managers with higher assets under management and more complex strategies will want to include counterparty, operational, and legal risk considerations across multiple structures, accounts or portfolios. To tackle these capabilities, managers should look for a platform that includes:


• Real-time multi-dimensional trade capture and aggregation;


• Cross-asset class, multi-broker, and destination functionality; • Risk sensitivity statistics; • Standard formulaic profit and loss; • Market exposure summations, by strategy, product, and account; • Risk control and limit-setting functionality; • One-click order cancellation, position fattening and administration;


• Early warning exception reporting.


Together, these capabilities can create new avenues of opportunity under a single umbrella of operations – achieving faster risk identification, better risk management, and smarter position adjustment and forecasting through position-aware standards and protocols.


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