Middle office functions in a hedge fund

Speaking to COO’s, Head of Operations and Industry players in the hedge fund community it’s not uncommon to find some disagreement about what operational functions constitute the Middle Office within a hedge-fund.

For the purpose of this blog and in my view the definition of operations covers functionality that is post-trade but pre-settlement and clearing from the trade lifecycle.

This would definitely include: Cash management, collateral management, trade affirmation / confirmation and reconciliation services. Expanded version of this definition may include value-add functions to provide real-time P&L, estimated NAV, internal reporting and valuation services although some of this arguably overlaps with front-office terminology. Fund accounting, shareholder servicing and custody for all intents and purposes are more back-office functions.

It is worth stating this definition now since future posts will look at the increasing number of service providers such as Prime Brokers and Administrators that are attempting to entice hedge funds with their outsourced Middle Office offering – if you combine the commoditised nature of many of these functions with the increasing pressures on fees it’s definitely something COO’s have to consider but very carefully and with due diligence.

$596 trillion and counting…

Thats the notional amount of outstanding OTC derivatives contracts as reported by the BIS’s for the second half of 2007. Commodities recorded strong growth with a 19% increase in notional volumes in the second half of 2007 to reach $9.0 trillion at the end of December. It would be reasonable to expect this trend to continue increasing the demand for electronic confirmations.

I would expect the DTCC and/or Swapswire to get into this space later this year or early 2009 but a pre-requisite might be for FpML Commodities working group to announce their first draft – due this summer according to their charter.

COMMENT: FpML, FIX, SWIFT and ISITC agree to play together

A fairly significant announcement was made yesterday by all the major players in financial messaging – FIX, ISO, FpML along with Swift. What they did was to outline an investment roadmap which provides a consistent direction in mapping standards against the major asset classes and business processes. Anyone following this space will have seen some overlaps start to emerge between these various standards leading to alternative approaches and confusion amongst practitioners, so this is clearly a welcome step forward which will see ‘best of breed’ protocols cementing their place in the roadmap.

The eventual objective seems to be to lay the foundation for ISO 20022 to become the common business model going forward for financial messaging and communication although no dates on this were announced, something that you might expect in a roadmap.

What does it mean for hedge fund operations ? Well from the outset its positive news since this leverages existing standards into a broader framework and should meant better ‘less risky’ investment decisions in technology can be made with greater reassurance that anything developed will be future-proof and interoperable with other external ‘utility’ systems. But fundamentally multiple protocols will be around as this does not present a unification plan just yet. In fact some of what has been suggested is already being used based on ‘common sense’ observations by experts in the field i.e. combining FpML and FIX to deliver OTC Derivative systems.

ARTICLE: OTC Derivatives Processing

Good write up by the ICFA about the processing challenges with OTC derivatives with comments from key players on the industry and utility side:

The enigma variations

by Kris Devasabai 7 March 2008

Rapid growth in the use of OTC derivatives within the asset management industry is creating a raft of new complications in the middle and back office. KRIS DEVASABAI reports

The evolution of the UCITS regulations in Europe and the move by pension fund clients towards liability driven investment strategies have spurred many traditional long-only asset managers to increase their use of sophisticated OTC derivative products.

Estimates from JPMorgan indicate that while only ten percent of fund managers invested in OTC derivatives currently have more than fifty open positions, the bank expects this figure to increase exponentially as the industry becomes more familiar with these instruments.

JPMorgan’s recent experience with major clients reveals that there is often a rapid jump to around five hundred open positions, followed by a more gradual increase to a few thousand.

But while the front office is rapidly developing an appetite for these complex instruments, the back office is finding the manually intensive processing requirements of OTC derivatives hard to stomach.

Read More here

ARTICLE: One hub to rule them all

The rapid rise in the use of STP for OTC derivatives trade affirmations and confirmations has triggered the establishment of a number of players over recent years with platforms from DTCC and SwapsWire dominating the market. However, the fact that no single provider has emerged as the prevailing platform has presented challenges for hedge funds. By Digiterre’s Ravi Sawhney

Hedge funds are not alone in this operational challenge – traditional asset managers are also affected due to the increased use of OTC derivatives in their retail funds facilitated by the loosening of investment regulations ushered in by the UCITS III directive. Several platforms are owned or sponsored by the sell side and their requirements, and as a result it is fair to say that, to date, the majority of the benefits are being realised by the sell-side institutions and not the …

Read further On BuySideTechnology

COMMENT: US copies Britain (… for a change)

A group of hedge funds and investors in the US is preparing to follow Britain’s example by issueing a set of sweeping new standards aimed at reducing systemic risk and promoting investor protection, reports the FT on Tuesday.

The “best practice” guidelines, drawn up by two committees formed under the President’s Working Group on Financial Markets last September, will be issued Tuesday as part of the efforts by Hank Paulson, Treasury secretary, to formulate a private sector-led response to concerns about the activities of secretive hedge funds and avoid potentially draconian regulations.

One recommendation is that hedge fund mangers disclose hard-to-value financial products, such as complex derivatives, which have been at the heart of the current market turmoil.

A summary of the report claimed that these and other new standards will be adopted by hedge funds with over $140bn in assets under management.

(source: FT Alphaville)

… again all guidelines and recommendations at this stage but a noteworthy start.

COMMENT: OTC Valuations Service from Northern Trust

Northern Trust launches its independent OTC valuations service in collaboration with Markit and SuperDerivatives

Read this also

COMMENT: Hedge Fund Valuations

Whats it worth?

There is growing concern from investors and regulatory bodies on both sides of the Atlantic about the valuation of funds that contain “hard to value strategies” . This is driven by the inherent difficulty of valuing complex or illiquid OTC assets and the potential conflict of interest between investors and fund managers.

AIMA recently published a paper to advise on the issue AIMA – Guide to Sound Practices for Hedge Fund Valuations, 2007 and the FSA in conjunction with the IOSCO also put forward their “Nine Principles for Hedge Fund Valuations“.

Both fundamentally call for the need of expert independent “valuation service providers” which typically should be the funds Administrator, however it is no secret that many Administrators struggle with valuing the more complex OTC products and in some cases they are only confirming the funds valuation instead of calculating it themselves against their own books and records as investors might expect.

As institutional money continues to flow into hedge funds expect the importance of valuations to result in the gap being filled by more niche Administrators that specialise in complex valuations and vendors such as Markit. The big Administrators are unlikely to stand still and may fill the gap through strategic acquisitions or through collaboration efforts with specialist vendors.

COMMENT: The FED barks again about OTC derivatives processing

Yet again the FED has drawn attention to the need for dealers AND they buy-side to accelerate the use of electronic means for trade confirmations and novations – interestingly (and perhaps unsuprisingly) in this note they also bring up the issue of ‘Credit Event Management’

Read the note here

Anyone know what the FSA has to say about this?

COMMENT: Sound Practices for European Hedge Funds by AIMA

Very readable and concise for what you get, useful for operations managers and team members as well as those looking to get a job in the hedge fund operations space.

Available here