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 John Burchenal
Executive Director, Market Growth
Over the past 10 years, the hedge fund industry has grown at an average rate of 20 percent per year and now has an estimated $1 trillion under management in the US alone. Once considered an investment tool by only the most sophisticated investors, hedge funds have now grown in appeal amongst a broader range of institutional investors, including pension funds. This rise in popularity has meant a greater demand for due diligence and transparency from investors and regulators alike and has shone increased light on the operational infrastructures of hedge funds. Robust, automated and transparent operations are necessary to reduce cost, lower risk and increase investor confidence.
Many hedge funds today still process trades manually. This means that funds are communicating trade information either via phone, fax or email. Since faxes can be lost, emails deleted and phone calls misinterpreted, these manual methods can create operational and market risk – an error-prone environment in which trades often fail to settle on time. Manual processing leaves no room for scalability or flexibility: as the number of trades increases, so does the time spent processing them. The increased use of algorithmic trading has only made the situation worse as the number of trades has increased precipitously.
As the leading provider of post-trade processing in the securities industry, Omgeo has naturally seen a big increase in its business from hedge funds in recent years. A significant percentage of new sales on Omgeo’s Central Trade Manager trade matching service are to hedge funds. Smaller funds are also turning to Allocation Interface, a web-based version of CTM. This is driven by the maturation of the hedge fund market and increased scrutiny from more sophisticated investors, resulting in a growing demand for automated trade processing - cost reduction and transparency.
Prime brokers, who are the key service providers to hedge funds, have been a strong advocate of electronic processing systems such as Omgeo CTM. In the U.S. prime brokers tend to be the affirming party in hedge fund trades, particularly for small and mid-sized funds. Prime brokers realize that hedge funds can reduce costs due to trade errors by automating the post-trade process. Fewer errors mean fewer failed trades, which translates into cost savings. One fixed income investment advisor using Omgeo noticed a 65 percent reduction in exceptions and 50 percent reduction in trade failures following automation via Omgeo. With increased competition in the hedge fund space over the past 12 months, streamlining processes and controlling costs is of increasing priority for fund managers.
Another benefit to hedge funds of electronic processing systems like Omgeo CTM is increased transparency. As more hedge funds evolve from being small, esoteric investment vehicles and cater increasingly to institutional investors, the pressure on them to be as transparent as possible is ever more intense. Trade process automation provides an auditable, electronic trail for each trade. Being able to demonstrate real-time STP also increases transparency in the trade process and supports compliance with the U.S. requirement that all trades must be confirmed with a Central Securities Depository.
Automated trade allocation and matching, versus manual processing, significantly reduces operational risk. These solutions also offer hedge funds the option of using multiple prime brokers, providing the comfort, should they require it, that no single broker holds the entirety of their investment positions and strategies. In addition, electronic solutions are volume-independent, meaning funds can easily scale-up as they grow and trading volumes increase. The upshot of it all is increased competitiveness: the less time and money spent on processing trades and exception management, the more focus that can be placed on executing trading strategies.
During the past ten years, demand for alternative investments has skyrocketed. As volumes have increased, so too have risk exposure and trade failures. Hedge funds are facing a tightening regulatory environment, increased pressures from trading counterparties such as prime brokers, and a growing focus on operational risk. In fact, in a recent whitepaper, CAPCO found that “operational issues account for an alarmingly high proportion of hedge fund failures (50 percent) and that expanding due diligence and monitoring practices to understand ‘back office’ capabilities can make a big difference in preventing or avoiding these failures.”
The time for widespread automation among hedge funds’ back offices is now, and more and more, hedge funds are turning to trade processing technology to manage these risks. However, there is much more progress to be made, as hedge funds realize it is only a matter of time before automation is no longer option but a necessity.
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