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Hedge Funds and OTC Products

Some hedge funds use OTC products as part of their main investment strategy, or as a supplement to their main strategy.  In either event, there are a number of issues which hedge fund managers should consider when they decide to utilize OTC products within an investment strategy.  First and foremost, the OTC investment strategy should be adequately described in the hedge fund’s offering documents.  Secondly, the manager should consider the “back office” requirements for processing the OTC investments.  The following article gives a good background of the OTC processing requirements and issues.

Please contact us if you have any questions or you are interested in starting a hedge fund.


The 5 Pillars of OTC Processing
Ron Tannenbaum, co-founder, GlobeOp Financial Services

As the OTC derivatives market expands in volume, complexity and sector interest, many funds face equally complex post-trade processing challenges in terms of operational processes & efficiencies. Can the key elements of a successful operational infrastructure to support a competitive OTC strategy be defined?

As a significant opportunity for alpha, the growing attraction of OTC derivatives is confirmed both at the industry level and on the “production floor”.  Supplementing Morse’s recent focus group confirmation that 64% of firms increased derivative contracts volume in the last 6 months, new trades by GlobeOp’s OTC clients in the same period increased 100%; monthly open positions increased 18%.

GlobeOp: Daily Average OTC Trade Volume

GlobeOp Monthly OTC open positions by Product Type, August 2008

In addition to traditional hedge fund activity, mutual funds liberated by the UCITS III directive are also increasingly including OTC derivatives in their trading strategies.  Exponential OTC volume growth, combined with the current market turbulence, is challenging in-house operational systems as never before. Legacy and “bolt-on” software systems struggle to communicate with each other. Spreadsheets strain to handle volumes and complexity they were never designed for, increasing the risk of error with each update. In parallel with portfolios becoming more complex, funds are facing increased investor pressure to demonstrate enhanced operational control, independent valuation, higher levels of disclosure and more transparent performance reporting. For many funds, processing derivatives internally quickly becomes cumbersome, inefficient and error-prone, increasing operational risk instead of delivering competitive advantage.

Is a water-tight process for OTC trade processing possible and if so what would it look like?
Eight years of daily OTC processing has provided GlobeOp with a crystallized perspective of the elements essential to a fund’s requirement for effective OTC derivative post-trade processing. Five core, integrated processes are needed to manage, track and report on trades end–to-end throughout their lifecycle:

  • Trade capture
  • Operations
  • Valuations
  • Collateral management
  • Documentation

Rigorous, reliable, daily reconciliation underpins much of the process, while scalability in terms of people and technology is needed to respond nimbly and promptly to trade volume growth, new products or unexpected market events.

The 5 Pillars

Trade capture – real-time, cross-product

Trade data entry sounds such a basic process that it is often underestimated as the cause of many issues further along the process. Incomplete and/or inaccurate detail risks being created when data is aggregated into an internal system from disparate silos or when bolt-on software is unable to communicate completely with front office configurations or legacy systems.

Also, due to their bilateral nature, derivative instruments do not always have established identifier codes, making them more difficult to process than securities with their standard ISIN, CUSIP or Bloomberg reference codes.

A real-time, cross-product, electronic trade capture environment can support the trading desk in developing and trading new OTC products.  Trades should only ever be recorded once, to eliminate the risk of errors associated with manual entry and spreadsheets.

Operations – the litmus test

Trade operations are the ‘litmus test’ of the entire process, encompassing the settlement of trades and reconciliation of cash and securities positions associated with individual derivatives transactions. Having cash and securities obligations in position at the time of settlement are essential to efficiently transferring ownership and moving funds.

Valuations – transparency, independence

The challenge of accurate, independent valuation can be addressed by pricing models that can adapt to new and complex instruments, and that are tolerance-checked against counterparty prices and other external industry and data sources.

Depending only on counterparty prices due to either insufficient valuation expertise or technology can increase the risk of a domino of delays to timely and reliable trade reconciliation, NAVs and investor reporting or returns.

Mutual funds face an additional regulatory dimension to their valuation challenges. In exchange for reducing mutual fund barriers to OTC derivative trading, the February 2007 UCITS III directive placed a high premium on transparent and independent valuation and risk management.

The requirement for mutual funds to demonstrate their ability to provide fully independent daily valuations and risk analytics can affect both mutual funds and their custodian bank. A mutual fund’s back office is often well-equipped to manage the long-only investments the fund traditionally makes. Operational knowledge, systems, models and capacity for complex derivatives is, however, either absent or insufficient. This is compounded when, as we have seen repeatedly, most mutual funds also initially tend to significantly underestimate their derivative trading volume,

Thus challenged, and to meet the UCITS lll independence criteria, the mutual fund turns to its custodian bank, its historic provider of a wide range of support services. While willing in spirit, most custodian banks quickly recognize that complex OTC trade processing, valuation and risk analytics exceed both their expertise and spreadsheet-based systems.

Collateral management – exposure management

Current market turbulence has sharpened the spotlight on the value of real-time, online collateral management to accurate trading and exposure management. What collateral is on the books, with whom, at what rate, for how long? What pledges are held vs. outstanding? Accurate, transparent collateral reporting will remain vital to the front office for months to come.

Effective collateral management usually includes ensuring the fund is net present value collateralised with each of its counterparties on a daily basis. In addition, an integrated facility should ensure appropriate movement of cash and securities to support revaluations and margin calls.

Documentation – integrated STP

According to recent ISDA statistics, approximately 60% of the hedge fund industry’s OTC instruments are still confirmed manually. This is not only time-consuming, but it also increases the incidence of error and leaves funds vulnerable to compliance risk, due to the high level of positions which remain based on verbal agreements. Integrated, straight-through-processing (STP) for managing, exchanging and storing trade documentation better enables both trade partners to reconcile economic terms with counterparties and meet auditor and regulatory compliance obligations.


A successful OTC trading strategy requires underpinning by an integrated platform of people, processes and technology that deliver post-trade processing and reporting that enables the fund to focus on its core objective of generating investor returns and expanding the capital base.

Informal industry estimates indicate that building an internal OTC processing infrastructure involves significant fund investment in cost and time — up to $50 million and five years of testing and development. Often unspoken are the risks that continued market and fund strategy evolution may result in a design neither suitable or scalable for long-term requirements, or able to deliver sufficient economy of scale.

The attraction of OTC derivative instrument strategies remains robust. As funds consider their future strategies, recent market events have only served to reinforce the need for post-trade processing and infrastructures whose key deliverables are:

  • Data and document management across the lifecycle of the trade that is timely, transparent, accurate, reconciled and real-time
  • Robust, scalable, online support
  • Independent, risk-based valuation that is tolerance-checked within well defined limits.

Hedge Funds and Counterparties: Report by GAO

This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds. The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.

I found this section reprinted below to be especially informative on the issues involved when hedge funds utilize credit.  The section provides a history on hedge funds and counterparty risk management and has concluded that the counterparty risk management procedures have tightened from the late 1990’s when we saw the crash of Long Term Capital Management.  It is likely that in this current environment that even stricter risk management procedures will become common and that due diligence by counterparties (banks and brokerage firms) will also increase.

If a manager has any questions on receiving credit or leverage, the manager should talk with the fund’s broker and/or banker well before any credit or leverage is needed – as always, managers are urged to give themselves plenty of time when negotiating credit and leverage terms.  Please feel free to contact us if you would like to discuss anything discussed herein.


Creditors and Counterparties Can Impose Some Market Discipline on Hedge Fund Advisers as Part of Credit Extension, but the Complexity of Counterparty Credit Risk Management Poses Ongoing Challenges for Financial Institutions:

By evaluating hedge fund management, the fund’s business activities, and its internal and risk management controls, creditors and counterparties exert discipline on hedge fund advisers. According to market participants, entering into contracts with hedge funds as creditors or counterparties is the primary mechanism by which financial institutions’ credit exposures to hedge funds arise, and exercising counterparty risk management is the primary mechanism by which financial institutions impose market discipline on hedge funds. According to the staff of the member agencies of the PWG [the President’s Working Group on Financial Markets, please see this article for more information], the credit risk exposures between hedge funds and their creditors and counterparties arise primarily from trading and lending relationships, including various types of derivatives and securities transactions.[1] As part of the credit extension process, creditors and counterparties typically require hedge funds to post collateral that can be sold in the event of default. According to market participants we interviewed, collateral most often takes the form of cash or high-quality, highly liquid securities (e.g., government securities), but it can also include lower-rated securities (e.g., BBB rated bonds) and less liquid assets (e.g., CDOs). They told us they take steps to ensure that they have clear control over collateral that is pledged, which according to some creditors and counterparties we interviewed, that was not the case with LTCM. Creditors and counterparties generally require hedge funds to post collateral to cover current credit exposures (this generally occurs daily) and, with some exceptions, require additional collateral, or initial margin, to cover potential exposures that could arise if markets moved sharply.[2] Creditors to hedge funds said that they measure a fund’s current and potential risk exposure on a daily basis to evaluate counterparty positions and collateral.

To control their risk exposures, creditors and counterparties to generally large hedge funds told us that, unlike in the late 1990s, they now conduct more extensive due diligence and ongoing monitoring of a hedge fund client. According to OCC, banks also conduct “abbreviated” underwriting procedures for small hedge funds in which they do not conduct much due diligence. OCC officials also told us that losses due to the extension of credit to hedge funds were rare. Creditors and counterparties of large hedge funds use their own internal rating and credit or counterparty risk management process and may require additional collateral from hedge funds as a buffer against increased risk exposure. They said that as part of their due diligence, they typically request information that includes hedge fund managers’ background and track record; risk measures; periodic net asset valuation calculations; side pockets and side letters; fees and redemption policy; liquidity, valuations, capital measures, and net changes to capital; and annual audited statements. According to industry and regulatory officials familiar with the LTCM episode, this was not necessarily the case in the 1990s. At that time, creditors and counterparties had not asked enough questions about the risks that were being taken to generate the high returns. Creditors and counterparties told us they currently establish credit terms partly based on the scope and depth of information that hedge funds are willing to provide, the willingness of the fund managers to answer questions during on-site visits, and the assessment of the hedge fund’s risk exposure and capacity to manage risk. If approved, the hedge fund receives a credit rating and a line of credit. Several prime brokers told us that losses from hedge fund clients were extremely rare due to the asset-based lending they provided such funds. Also, one prime broker noted that during the course of its monitoring the risk profile of a hedge fund client, it noticed that the hedge fund manager was taking what the broker considered to be excessive risk, and requested additional information on the fund’s activity. The client did not comply with the prime broker’s request for additional information, and the prime broker terminated the relationship with the client.

Through continuous monitoring of counterparty credit exposure to hedge funds, creditors and counterparties can further impose market discipline on hedge fund advisers. Some creditors and counterparties also told us that they measure counterparty credit exposure on an ongoing basis through a credit system that is updated each day to determine current and potential exposures. Credit officers at one bank said that they receive monthly investor summaries from many of their hedge fund clients. The summaries provide information for monitoring the activities and performance of hedge funds. Officials at another bank told us that they generally monitor their hedge fund clients on a quarterly basis and may alter credit terms or terminate a relationship if it is determined that the fund is not dealing with risk adequately or if it does not disclose requested information.

Some creditors also said that they may provide better credit terms to hedge funds that consolidate all trade executions and settlements at their firm than to hedge funds that use several prime brokers because they would know more about the fund’s exposure. However, large hedge funds may limit the information they provide to banks and prime brokers for various reasons. Unlike small hedge funds that generally depend on a single prime broker for a large number of services ranging from capital introductions to the generation of customized accounting reports, many large hedge funds are less dependent on the services of any single prime broker and, according to several market participants, use multiple prime brokers as a means to protect proprietary trading positions and strategies, and to diversify their credit and operational risks.

Despite improvements in disclosure and counterparty credit risk management, regulators noted that the effectiveness of market discipline may be limited or market discipline may not be exercised properly for several reasons. First, because large hedge funds use several prime brokers as creditors and counterparties, no single prime broker may be able to assess the total amount of leverage used by a large hedge fund client. The stress tests and other tools that prime brokers use to monitor a given counterparty’s risk profile can incorporate only those positions known to a trading partner. Second, the increasing complexity of structured financial instruments has raised concerns that counterparties lack the capacity (in terms of risk models and resources) to keep pace with and assess actual risk, illustrating a possible failure to exercise market discipline properly. More specifically, despite improvements in risk modeling and risk management, the Federal Reserve believes that further progress is needed in the procedures global banks use to manage exposures to highly leveraged counterparties such as hedge funds, in part because of the increasing complexity of products such as structured credit products and CDOs in which hedge funds are active participants. The complexity of structured credit products can add to the already complex task of measuring and managing counterparty credit risk. For example, another Federal Reserve official has noted that the measurement of counterparty credit risk requires complex computer simulations and that “the management of counterparty risk is also complicated further by hedge funds’ complicated organizational structures, legal rights, collateral arrangements, and frequent trading. It is important that banks develop the systems capability to regularly gather and analyze data across diverse internal systems to manage their counterparty credit risk to hedge funds.” One regulatory official further noted the challenges faced by institutions in finding, developing and retaining individuals with the expertise required to analyze the adequacy of these increasingly complex models. The lack of talented staff can affect counterparty credit risk monitoring and the ability to impose market discipline on hedge fund risk taking activities. Third, some regulators have expressed concerns that some creditors and counterparties may have relaxed their counterparty credit risk management practices for hedge funds, which could weaken the effectiveness of market discipline as a tool to limit the exposure of hedge fund managers. They noted that competition for hedge fund clients may have led some to reduce the initial margin in collateral agreements, reducing the amount of collateral to cover potential credit exposure.

[1] A derivative is a financial instrument, such as an option or futures contract, the value of which depends on the performance of an underlying security or asset. Securities financing transactions include repurchase agreements, securities lending transactions, and other types of borrowing transactions that, in economic substance, utilize securities as collateral for the extension of credit. A repurchase agreement is a financial transaction in which a dealer borrows money by selling securities and simultaneously agreeing to buy them back at a later date.

[2] According to the literature, (1) current exposure represents the current replacement cost of financial instrument transactions, i.e., their current market value; (2) potential exposure is an estimate of the future replacement cost of financial instrument transactions; and (3) an initial margin is the good-faith deposit that protects the counterparty against a loss from adverse market movements in the interval between periodic marking-to-market.

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