Alternative Investment Management Association Representing the global hedge fund industry
Hedge fund managers have a unique range of requirements that require extensive utilisation of mobile communications. This reliance has, however, created a growing blind spot of risk management issues that not only affect trade but also fuel the regulatory, media and investor concerns about the industry.
During the course of the deepening global financial crisis, the hedge fund business has fallen under the spotlight of the media, financial regulators and consequently investors. Questions are being asked as to how accountable and responsible are the companies who manage these funds.
Both the SEC and FSA have attempted to toughen up regulations to include hedge funds in areas of governance that did not previously apply. September saw both organisations ban short selling and, although a permanent ban is unlikely, the focus on hedge funds needs to be diffused. With the Committee of European Securities Regulators also considering a crackdown, it is time for investment managers to be clear on where they could be exposed to criticism or prosecution in the future.
Regulation and the global financial crisis are not the only catalysts for this increasing attention. Since the Enron scandal, the US has targeted accounting fraud, insider trading and deceptive sales practices. Robert Mueller, director of the FBI, announced in April that the number of corporate fraud cases investigated by the FBI has increased by more than 80 percent since 2003, with more than 490 corporate and securities fraud convictions made in 2007.
High profile cases have made hedge funds a clear target as defendants have repeatedly found it difficult to demonstrate a responsible and transparent approach to monitoring their deals.
A growing unease amongst investors is, undoubtedly, being compounded by both the media and legislators who refer to hedge funds as a risk to both the entire financial system as well as to investors. Considering that investment managers constantly manage risk and their clients are aware of the risks, there is a certain irony to the accusations.
However, positive action is needed to maintain or restore investor confidence. This view was substantiated recently by PricewaterhouseCoopers (UK) who concluded that, increasingly, hedge fund investors are going to require more robust operational controls and risk management systems.
Confidence comes from knowledge, trust and accountability. Financial services have always maintained records of transactions, agreements and results. Unfortunately, they were designed for offices where management controlled the activities of its employees in a closed environment. From basic countersigned orders to sophisticated e-mail logging, there has always been a ‘paper trail’ to assist managers in defending, prosecuting or monitoring their employees. The legislative requirement for recording telephone calls was introduced to not only assist with FSA prosecutions but also to enable management to resolve disputes, re-assure clients and create a deterrent for rogue traders. The FSA considers that recording of voice conversations helps regulated firms and the FSA detect and deter inappropriate behaviour and encourage increased market confidence.
The world has now moved on and the office environment is no longer the only place where trading occurs. This is particularly true with hedge fund managers.
Unlike the majority of traders, hedge fund managers are reliant on mobile communications to carry out their business. The FSA estimates that 41 percent of all financial service firms make ‘relevant’ trading conversations on mobile phones; usage by hedge fund managers is undoubtedly far higher. Most hedge fund managers spend over 100 hours per week on the road talking to investors, seeking out investment ideas and receiving information whilst on the move. In a recent interview with The Sunday Times, ISAM chief executive, Stanley Fink admitted that he has three mobile phones whilst Nancy Havens of Havens Advisors told Forbes Life that she cannot afford to lose a cell phone signal “for even a few minutes” and that she once made a trade whilst cycling on holiday in Italy! The risk with this extensive reliance on mobile technology is that managers cannot produce the evidence or accountability available to their office bound colleagues.
In order to address the above issues, hedge fund management companies should consider introducing their own standards without being coerced by the whip hand of regulation. Just as landline call recording systems have managed risks with good record keeping, the technology is now available to extend the same benefits to mobile communications. Mobile call recording is a risk management issue that would help to diffuse many criticisms levelled against the industry. The voluntary adoption of the technology would demonstrate good governance to investors and regulators, whilst also safeguarding twenty-four hour trading conditions and transactions.
Any advice, deals, transactions or other verbal agreements that have taken place over unrecorded mobile phones are a major source of risk that undermine existing investments in landline recording systems. The introduction of mobile phone call recording will ensure that senior management will be seen by stakeholders and regulators to have taken all reasonable steps to manage risk.
In March this year, the FSA released Policy statement PS08/1 regarding “Telephone Recording: Recording of voice conversations and electronic communications”.
The statement includes a major section (COBS 11.8.5 R) that proposes the need for financial services companies to record mobile phone conversations. The section does reveal that, with technology now available, mobile phones will be included in the future but are exempt from legislation until a planned review in September 2009. Interestingly, this is likely to coincide with an EU review regarding the addition of a taping requirement under the Markets in Financial Instruments Directive (MiFID).
The FSAs independent consultants stated in the FSAs Policy Statement PS08/1* that, “…it seems unlikely to make regulatory sense to record landlines if you cannot cover mobile phones as well, (otherwise one creates clear incentives to conduct illicit conversations through mobile phones and the cost of installing and maintaining the fixed-line only recording machine is incurred for no reason)”.
It is also important to realise that the proposals include, “…all telephone conversations and electronic communications (except e-mails) made with, sent from or received on a mobile telephone or other mobile handheld electronic communication device”.
Should senior managers of hedge funds introduce these measures before the rest of the financial services sector, then both the short term PR benefits and the long term advantages would be significant in restoring investor confidence and supporting effective trades.
Key success factors for mobile call recording should include:
• Identification of the risks that mobile call recording would help mitigate
- by looking at customer complaint files and the company’s litigation history.
• Mandating a company security policy
The decision to record mobile calls needs to be mandated at executive level, with input from the Compliance Officer and communicated to employees as a company security policy.
• Assessing the wider operational impact.
Is there a clear preference for an on-site solution integrated with existing recording and PBX systems or a remotely hosted system?
• Defining which mobile devices should be recorded day to day
Who will be recorded and why, with regard to potential regulatory requirements and risk profiles?
• Defining scenarios where recording should be applied to devices on a temporary basis or at the user’s discretion.
Are there defined risk scenarios for mobiles that should be recorded but are not, ordinarily?
There are a number of ways to record phone conversations. However, the most appropriate for mobile phones is a software based solution that can be deployed automatically to handsets without the need for expensive hardware. The advantages of these kinds of system are twofold - simplicity and cost, with the added benefit that they are often available “off the shelf” and can utilise existing fixed line recording equipment. The schematic below shows typical arrangements for on-site and hosted software systems:
Whilst a reputation for integrity is built over time, it can be destroyed quickly. Furthermore, there is always the risk of the damaging impact of disputes, litigation and regulatory investigations. This risk is governed by the strength of an organisation’s internal controls.
Record keeping is a central pillar of internal controls and this now includes the recording of relevant phone calls. By not recording mobiles, landline recording is rendered pointless and the risk to a hedge fund’s reputation and secure trading is left unmanaged.