Best practices: the optimal investment management system for regulatory compliance

New financial legislation being passed across the globe will have sweeping repercussions on the technical and IT structures of investment management organisations. Based on interviews with three global consultancies, Michael Metcalfe, Co-Editor of the Journal of Applied IT and Investment Management, discusses the choice of investment management system when it comes to gearing up to meet the regulatory challenge in a post-crisis environment.

By Michael T. Dolan, Partner at Ernst &Young LLP, USA;Sriram Venkataraman, Financial Services Executive, Ernst & Young LLP USA;Dushyant Shahrawat, Research Director at TowerGroup, USA

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Since the collapse of a number of global financial institutions in 2008 unleashed the full force of a global financial crisis, the ripple effects of which are still being felt, the financial services sector in general and the investment industry in particular have witnessed sweeping changes in the way they do business. Both the buy-side and the sell-side of the industry have had to contend with a wide range of pressing issues, ranging from depressed investor confidence and declining asset prices to corporate restructuring and business re-alignment.

Although much of the investment management industry has rebounded over the past 18 months, principally through rising stock markets, this has occurred against a continuing backdrop of radical industry change, much of which is contradictory in nature. Over the past two years, regulators and, increasingly investors, have progressively demanded new and improved levels of service and transparency from industry players.

At the same time, many of these same businesses have needed to focus on cost reduction and control in an attempt to remain competitive and maintain profit margins. For the majority, less internal resources have been available to satisfy new client demands and to develop new products and processes to cope with increasingly fierce market competition, especially from the larger players and new entrants to the market.

Notwithstanding improving market conditions across the globe, the investor population at large remains circumspect and risk adverse. These market dynamics have maintained pressure on business processes. As a result, many players are re-assessing their existing business models, technical operations and the relationships that support these processes, at the same time as seeking to improve risk management oversight and control.

NEW WAVE OF REGULATIONS AND STANDARDS

Whereas industry changes over the past two years have stemmed primarily from the prevailing market conditions, the next three to five years will see a wave of new regulations and standards that have been in the making for some time finally implemented across the globe, but principally in Europe and the USA. Combined, this new regulatory patchwork will impact the full spectrum of banking and financial services, trickling down to investment and securities operations and significantly changing the way in which these are undertaken, with the result that participants across the value chain will need to modify the way they operate and interact.

In the case of Europe, the principal EU-wide regulatory measures include the new UCITS IV Directive; MiFID conduct of business, including rules regarding point of sale or distribution of financial products and the way in which this directive will interact and support the new UCITS directive; a potential EU Directive on Packaged Retail Investment Products (PRIPs); and new UK-based regulations from the Retail Distribution Review (RDR).

In the USA, the new regulations being passed will have a far-reaching and investments industry, affecting competitive positioning of firms, market structure, revenue growth, profitability and IT budgets. New regulations create opportunities for service providers to help hedge funds meet registration requirements, assist with over-the-counter (OTC) derivatives valuation and clearing, monitor capital adequacy and leverage limits, and promote risk management and compliance.

UCITS IV AS DRIVER

Of the regulatory measures being enacted in Europe, UCITS IV is probably the one having the most impact on the investment management industry in the immediate future. While cost savings is a key driver at the industry level, the increased complexity and the ensuing operational challenges brought about by UCITS IV may actually lead to some additional cost pressures at the organisational level. For starters, firms will need the necessary IT expertise and systems to handle multiple languages and tax issues.

Additionally, the management company passport is still subject to tax issues that will have to be closely considered before making restructuring decisions. Fragmented tax regimes could mean that the use of the management company passport and cross-border fund mergers pose risks, such as double taxation to investors.

To rise to the challenge of UCITS IV, investment managers will have to build into their IT best practices the necessary technical and operational functionalities to deal with: 1) selling across multiple countries; 2) administering across multiple legislations; 3) coping with tax issues across multiple markets; 4) remaining compliant in the face of growing regulatory complexity.

Understanding the intricacies and nuances of UCITS IV will be important as well to ensure the organisation’s technology and operational processes are aligned successfully. While fund managers concentrate on their core competency of managing money, outsourcing operational solutions offers one way to meet challenges on the manager’s own terms. European asset managers should take the time now to better understand UCITS IV’s array of operational challenges to determine which can be met by internal versus external resources.

UCITS IV BEST PRACTICES

As UCITS IV will be the first of many EU regulatory changes to be implemented in the next few years and, while the majority of the new provisions are optional rather than mandatory, it will have a major impact on the choice of best practices involved in the administration and distribution of UCITS funds. Now that Level 2 implementing regulations have been published, the fund industry is looking to fully assess the business and IT implications of UCITS IV.

Of paramount importance will be to determine the strategic and best-practice decisions, whether regarding product, process, administration or distribution, that will be required against a backdrop of increasing competition in a market that may not experience the same levels of growth in the foreseeable future as has been the case over the past decade.

The key best-practice question asked by many investment managers is: how can the different parts of UCITS IV be utilised to maximise administrative and technology efficiencies and yet enhance distribution and net sales in order to promote growth? While some of the compulsory measures of UCITS IV are currently perceived as additional burdens (i.e. KID and management company-related harmonised organisational and conduct of business rules), this may not necessarily prove to be the case, especially in the long-term perspective. Other UCITS IV measures (i.e. mergers, master-feeder structures, the management company passport and streamlined product notification) have the potential to boost economies of scale, enhance efficiencies and implement best-practice investment management system solutions.

MAJOR US REFORM ISSUES

Turning to the USA, six issues will become major business priorities owing to regulatory reform. These are in turn:

Risk management
The largest opportunity that the new regulatory environment creates will be in helping investment organisations retool their risk management departments. An intense focus on risk will be driven by pressure from shareholders to better manage company-wide risk, whether arising from the expected requirements of Basel III to the many provisions of the Dodd-Frank Act that relate to risk management and the demands placed by the new Office of Financial Research (OFR).

For example, investment companies will be assisted in managing risk by integrating their accounting collateral and reporting systems, improving attribution analysis, and cleansing and standardising data. Proven expertise will be required in helping investment companies address their risk management needs.

OTC derivatives reform
The Dodd-Frank Act will bring influential changes to the OTC derivatives market, creating opportunities for solutions related to collateral management, centralised clearing, real-time reporting and monitoring of positions. Under the reform, many OTC derivatives will have to be shifted to a central clearing model owing to more transaction volumes and related services. A major overhaul of the OTC derivatives business is therefore inevitable, bringing with it implications for choice of best-practice system solutions.

Hedge fund registration
New rules affecting the alternative fund sector will make fund managers demand services ranging from SEC audits and compliance checks to performance reporting and valuation. Over the next few years, regulatory changes will oblige the alternative fund sector to prepare investment management systems for SEC registration, more transparency and disclosure requirements, greater regulatory scrutiny, and a stronger internal risk management and compliance department.

This reform calls for expertise alternative fund accounting, reporting and client management systems. Systems integration and expertise will be required on the part of investment management companies in relation to their alternative fund operations, compliance and reporting.

Leverage and capital adequacy
A common and unifying theme running across several regulatory requirements is stricter limits on the amount of leverage that investment management operations can assume, greater capital required to be held on the books and frequent and more comprehensive reporting of leverage and capital held.

To meet these demands, institutions will need to undertake a three-step process. They will need to monitor securities positions more and more in real time, aggregate their exposure across all lines of business and be able to report and manage it in line with requirements embodied in the Collins Amendment. Investment management organisations will require support for all these tasks for one of several reasons: in most cases, they simply do not have the in-house skills to do this work, they lack the skilled personnel to do it, or external suppliers can do it more cost-effectively.

Asset valuations
Several new accounting rules affect the process and methodology that investment management companies use to value securities positions, particularly illiquid instruments. New Financial Accounting Standards Board (FASB) rules, as well as new International Accounting Standards Body (IASB) rules governing securities valuation, will require companies to alter their accounting and general ledger systems, use third-party providers for independent valuations and better report valuations to outside parties.

In addition, the Dodd-Frank Act will not only require public companies to report securities positions to shareholders and regulators but also require private equity and alternative hedge funds to begin reporting positions (to general/limited partners, to regulators, to the OFR and even to prospective clients). This will mean demand for integrated solutions that provide key inputs into the valuation process.

Audit and compliance
Investment management companies will feel the heat from more frequent and invasive audits and much greater regulatory oversight from the SEC, CFTC, Federal Reserve, and Consumer Financial Protection Bureau. SEC investigations of alternative hedge funds have steadily risen over the last few years from 776 in 2007 to 944 in 2009 and an estimated 1,050 in 2010. New powers, a US $100 million budget increase, and the authority to hire 1,000 new employees will mean that investment organisations will be contending with a much more empowered SEC.

The Federal Reserve and the OFR will also exert greater regulatory oversight and influence on influential investment companies like Morgan Stanley and Goldman Sachs and large alternative funds that are deemed to be systemically important. This will increase the need for compliance software, audit preparation, employee surveillance and related services.

GROWTH CHALLENGES

As regulatory requirements and client demand drive change, investment management organisations will need to re-appraise their investment management software systems in order to adopt best practice. Among the most important points for consideration include the way data is stored. If data is stored in several databases or systems, including spreadsheets, it becomes difficult to obtain a true indication of risk exposure, as well as to gain insight into liquidity, valuations and similar metrics. Valuable time and resources are spent on trying to consolidate disparate data sources into a clean and true picture of the business.

In addition, companies will find that due to limitations in their investment management software system, there is an abundance of manual processes and duplicate data entries, which consume resources and result in higher error rates. Further, many months – or even years – may lapse between new releases or upgrades to the system; which forces diversion of IT and other resources to creating workarounds in order to comply with new legislation and regulation.

The company then finds itself in the situation of swimming against the current just to keep up with the tide of new regulation, rather than dedicating time to growing the business. Finally and perhaps most importantly, the system does not support all asset classes and financial instruments, thereby limiting the opportunities to grow through expanding investment offerings.

SYSTEM SOLUTIONS

An optimal software system embedded in the technology processes of the individual investment management organisation addresses all of the above points by providing a core system based on a single data source, combined with as high a degree of automation as is possible. The system should be frequently updated and provide coverage of all asset classes and financial instruments.

From a technology point of view, the investment management system must be able to incorporate regular changes to workflows and processes, as well as scale to accommodate higher transaction volumes, new asset classes and new funds and portfolios. Such a best-practice investment management system allows investment management organisations to focus on their core competency of adding value for clients rather than devoting an inordinate amount of resources to operations and system workarounds.

With unprecedented regulatory activity and more stringent client demands on investment managers, it has become categorically imperative that investment management organisations have the right and even optimal technical infrastructure in place to support their desired growth strategy. Companies need to feel confident that the software systems they adopt or have in place can handle ongoing regulatory compliance. Only in this way can they ensure that core competencies are directed at realising the organisation’s growth potential.

Michael T. Dolan is a Partner at Ernst &Young LLP and is based in Washington DC. He is part of the organisation’s Advisory practice where he helps clients improve the overall performance of their operations, accounting and financial reporting processes. Michael Dolan specialises in implementing new portfolio accounting and analytical reporting systems for portfolios of investments, debt, and derivative products. He holds a Masters degree in Quantitative Finance and is a Certified Public Accountant (CPA).

Sriram Venkataraman is an Executive in the Financial Services Office of Ernst & Young LLP and is based in New York, USA. He is part of the organisation’s Advisory practice and has experience in market risk management, financial derivative pricing models and trading system implementation. Sriram Venkataraman’s client base covers major money centre banks and financial institutions.

Dushyant Shahrawat is a Senior Research Director at TowerGroup in the Securities and Investments practice, Boston, USA. With over 15 years of experience in financial services, he is a Chartered Financial Analyst (CFA) and a member of the Boston Security Analysts Society. Dushyant Shahrawat researches strategic issues facing asset managers, hedge funds and brokerage firms globally, and advises clients about strategy, marketing, regulation, technology and product development. He has shared his opinions on financial industry trends at over 100 events across the USA, Europe and Asia and has appeared on various television and radio channels. He has also been widely quoted in printed publications such as the Wall Street Journal, New York Times, Fortune, and the Financial Times.