Sailing in uncharted waters: The regulatory tide turns for hedge funds

By Michael Cummins, FINBOURNE Technology

Published: 27 June 2022

2021 marked a strong and eventful year for global hedge funds, with total invested capital rising from US$3.58 trillion in 2020, to an unprecedented US$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.

However, the scale of global assets under management has not gone unnoticed and we now see 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, more prominently, the US Securities & Exchange Commission (SEC) has created ripples across the hedge fund industry, with ambitious proposals set to improve market transparency.

In their press release earlier this year[2], the SEC stated the proposed disclosure rules will ‘enhance the Financial Stability Oversight Council’s (FSOC) ability to assess systemic risk, as well as, 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.

According to AIMA, ‘these far-reaching proposals represent a major overhaul of existing market practices.’ But as the industry unpicks the proposals and forms its response, the question remains, how will these regulations impact hedge funds across the globe operationally, and how will managers continue to secure capital allocations and respond to market opportunities, while sailing in these unchartered waters?  

Systemic risk prevention or 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 them bracing themselves against a changing tide. Having ‘identified significant information gaps’ over a decade’s worth of data, the SEC, under the charge of Chairperson, Gary Gensler, is effectively intensifying its focus, starting with larger funds of US$2+ billion AuM, before dropping to include funds of US$1.5 billion AuM.

Pushing the envelope further than ever, the commission requires 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 meet this, 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 playing a role in past capital market events. This includes the now famous Archegos case and the recent 2020 US treasury market crash, where the hedging of treasury bonds and futures, contributed to a US$90bn loss in the market and caused a sticky 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 and AIMA are hitting back at the proposals. While, according to the Financial Times, several US firms are pursuing a legal challenge, questioning whether the SEC has properly assessed the cost benefit analysis. There is also an argument of whether further transparency would really limit systemic risk - arguing that they only serve to add ‘unnecessary paperwork’ and according to some, more ‘red tape’[3].  

The trouble isn’t just with the scope of the reporting, it is the T+1 timeframe that the SEC is demanding, that is causing the primary concern. 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’.

To meet this demand, 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. For the majority of small-medium hedge funds, meeting this regulatory mandate with the current host of systems and processes is going to be a challenge at best, and impossible at worst. Considering these rules form part of the SEC’s aspiring policy reforms, spanning issues from ESG, to cybersecurity – the current proposals may well be the tip of the iceberg.

The impact on hedge fund operations

The new rules may accelerate the urgency some hedge funds are already noting when it comes to addressing operations and will act as a litmus test for 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 stakeholder reporting.

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 operational challenges and market opportunities funds are facing, including those around regulatory requirements and investor due diligence, can be addressed by cloud-native data management tools, which tackle the root cause. 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 these funds will be doing this at lower cost, with greater operational ease and without taking their eye off the ball.

Emerging technologies, such as cloud-native, SaaS solutions can reduce operational effort and increase agility. When combined with PMS capabilities, SaaS data management solutions enable 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 transparent oversight, enhanced control, and innate financial sense. These technologies also make it easier to operate in a proliferated data environment and excel at translating large volumes of complex, multi-asset data, including ESG, alternative and newer asset classes, such as cryptocurrencies.

Importantly, the benefits of a modern data stack also extend 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.

Future-proofing growth in a regulatory climate  

By adopting an interoperable approach to hedge fund operations, funds can de-risk operational change and ensure business continuity in an increasingly regulated market, all while achieving scalable and resilient operations. Without it, navigating through an evolving regulatory storm will prove testing. More than anything, improving operational infrastructure and data processes, mitigates regulatory cost and operational risk, so funds can confidently meet regulatory and investor demands, while securing the allocations that will their fuel growth.