June 2008


Compliance monitoring was easy enough when domestic equities dominated fund managers’ portfolios, but now it has to cope with unconstrained mandates and cross-asset funds that cover multiple jurisdictions. Nicholas Pratt examines how compliance technology is evolving ... Ever since the financial services world became swamped with regulation, compliance technology has been a fairly easy sell. When the industry’s supervisors unleashed a raft of global regulations on financial institutions – from anti-money laundering to Basel II, to financial reporting and accounting standards – it was like a permanent Christmas for many compliance technology providers.

Enthusiasm overcame some providers, however, as their somewhat alarmist sales pitches implied that without the latest Acme compliance solution, companies would be doomed. More recently, as the regulatory rush has decelerated with the passing of Basel II and MiFID, there has been a renewed focus on the core aspects of compliance.

For fund managers this focus is typically on the limits and constraints that are mandated by their investors and the technology that is used to monitor trades and transactions to ensure that these mandates are adhered to.

The buy-side traditionally used ‘point solutions’ for this compliance monitoring, as it did for most of its operations. These were software products designed specifically for a single and well-defined task. In a compliance monitoring context, these systems would be designed to monitor the constraints set around specific instruments – if a fund consisted of mostly vanilla instruments, then this is what would be monitored.

Similarly these point solutions would be designed to fit specifically with the firm’s order management system, typically a large and mature system based on legacy technology into which everything flowed, including the compliance monitoring technology.

But different times call for different tools. Fund managers have been embracing more adventurous investment strategies with many of the more sophisticated portfolios combining long and short selling, domestic and international markets, and constrained and unconstrained mandates. Consequently the traditional, point solutions used for compliance monitoring are finding it difficult to cope with this more complex market.

“Traditional buy-side systems are beginning to creak,” says Chris Leong, operations director at Misys Eagle Eye, a compliance monitoring system. “We can no longer work with point solutions because the market is moving so much quicker.”

As well as the inability to cope with the computational requirements of modern-day trading, the point solution approach has a tendency to lead firms to look at compliance as a collection of separate requirements rather than an ongoing, enterprise-wide concern.

For example, says Tom McEvilly, sales director UK at US-based compliance provider CheckFree, MiFID has concentrated a lot of compliance concern on the issue of best execution and the ability to have transparent pricing at both pre- and post-trade level. However, this pursuit of best execution may take a fund outside of its original mandate or investment strategy if it is carried out in isolation. “It is a case of being too focused on the micro-level details and neglecting the macro-level benefits,” says McEvilly. “It is a paradox of compliance.”

Focus on flexibility
In order to avoid this paradox and to keep up with the ongoing sophistication of fund strategies and mandates, fund managers should be looking at creating generic monitoring platforms that are not rigidly designed to perform solely specific tasks but comprise a set of flexible tools that can be easily modified and customised to match future market requirements, says Leong. “This is something that has been very successful on the sell-side, which is traditionally a more complex monitoring and compliance environment and where compliance is linked closely with risk.”

The linking of compliance and risk is the key area of development for most vendors and is a task that is made easier by the use of component-based architecture, says Leong, as it allows risk and compliance systems to be intertwined, along with the transaction system, on one single platform.

“For a particular type of trade the first step is to define it,” says Leong. “From that it is possible to run a Monte Carlo simulation in order to perform the Value at Risk (VaR) calculation. We can then monitor the outputs of the risk engine against the limits or constraints set by the fund managers.”

This intertwining of the risk and compliance functions is something that is being pursued by many compliance vendors – not least because there has been a general integration of these two roles ever since the release of new international accounting standards (IAS39) back in 2001.

“There is an increasing convergence between the compliance and risk function,” says Hervé de Laforcade, head of projects for SunGard’s Asset Arena product. “It is harder to differentiate what belongs to rules-based constraints on investment portfolios in terms of currencies, assets, securities and what is related to risk, such as VaR and expected tracking error.”

With this in mind, De Laforcade says that the kernel of any compliance monitoring solution should be the ability to track the market risk induced by securities criteria or any impact on VaR.
Firms also have to factor in the demand for real-time, rules-based calculations and the ability to aggregate all of these calculations to a centralised compliance engine.

The next stage is the ability to link the aggregated data within this rules engine to the calculations run by the risk engine. “To do this you need a high level of performance and a system able to process multiple risk calculations at a tremendous pace,” says De Laforcade. “The timeframe for these calculations has to fit the timeframe in which an investment manager is able to make a trading decision.”

For those fund managers looking to use rules engines to not just manage various investment constraints but to also analyse and report the potential risk impact on the portfolio of every trade, then a link needs to be made between rule engine and a robust database with the ability to collect and process a mass of figures in real-time. “This is the big challenge facing the industry,” says De Laforcade.

At the moment the vendors are in that transitional phase between having devised the theory and then having proved it in a practical context. For post-trade purposes it is more a case of the volume of data rather than the response time.

Most of the challenges lie in the demands of pre-trade compliance, says De Laforcade.

“You have to deal with investment restrictions and alerts that can be sent when a trader is approaching their limits. This is a challenge in itself to have these alerts working in real-time. If you were to add the risk impact of these investment rules on top and any other additional aggregates that are not inside the compliance engine and its memory and need to be integrated from an external data source, then the process becomes tricky.”

The process needs to be synchronous and with an instant response time. The key is to address the structure of the data repositories that are used for compliance monitoring. To ensure high performance, De Laforcade suggests designing a data model that is as close as possible in its structure to that of the data model of the core system where the trades or valuations are performed – be that a portfolio management system, a fund accounting system or a position keeping system.

Sourcing data
Once these performance obstacles are navigated, the next task is coping with the sourcing of the data – a task that has been made far harder with the move to more complex strategies and more adventurous mandates. “These compliance engines have to be fed by a proper and reliable source of data,” says De Laforcade. For the likes of US and UK equities finding this data is not a problem but when it comes to fund-of-funds and emerging markets with small stock exchanges and less liquidity, then this data is harder to find.

Fund managers have to be assured that this data is reliable and if this data is not available this additional, operational risk must be factored into trading decisions. “It is all about data and the ability of a compliance solution depends on the quality of data that is fed into it. The days of a compliance tool that is plugged into just one source of data are long gone,” says De Laforcade.

Just as the vendors state that the old, point solution-based approach to compliance led firms to look at compliance as a collection of separate tasks, is the pursuit of a wholly integrated, enterprise-wide approach to compliance with a sophisticated and powerful rules engine at the centre of everything possibly going too much towards the opposite extreme? Will such
an approach compromise the ability of fund managers to devise new strategies?

De Laforcade thinks the opposite. “Compliance should not slow down the launch of a new product and I don’t see why it would,” he says. “Compliance follows investment decisions. You have to first design the type of portfolio you want to build and the objective you want to deliver to your clients in accordance with their expectations. Then you go to the compliance officers.”   

Reaching a consensus
Furthermore, if firms manage to successfully set up a compliance monitoring system that spans front, middle and back offices and is linked by what CheckFree’s McEvilly refers to as ‘cornerstone processes’, then this should bring compliance officers, risk managers and front-office staff all closer together. “These types of systems give firms a common denominator which enables them to get consensus on risk strategy and minimise any differences there may be in these areas between front and back office,” says McEvilly.

A compliance system built along these lines would also be accumulating so much data that it should not be beyond expectation for it to aggregate this data, form models and, ultimately, be able to suggest fund strategies which can then be reviewed and moved into the front-office framework. As De Laforcade says: “Compliance is not just about producing rules and results. It is about the ability to get positions, valuations, holdings, price, security master data, risk elements and figures, ratings and so much more.” ©  2008 funds europe

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