October 2015

Hedge Funds & Derivatives 2015

How to make risk Will regulation AIFMD and the management more help or hinder mutation of risk strategic derivatives risk? management CONTENTS In this issue…

03 How to make more strategic By James Williams

05 AIFMD and the mutation of risk management Interview with Alan Picone, Kinetic Partners

09 ODD comes under the microscope Interview with Kristin Castellanos, Deutsche Bank

11 A new view into fund By Chris Kundro, Wells Fargo Global Fund Services

12 Will regulation help or hinder derivatives risk management? By James Williams

15 A fully hosted and customisable risk solution Interview with Ittai Korin, PortfolioScience

18 Delivering real-time risk that reflects the speed of the market Interview with Martin Toyer, TFG Financial Systems

Publisher

Editor: James Williams, [email protected] Managing Editor (Wealth Adviser, etfexpress & AlphaQ): Beverly Chandler, beverly.chandler@ globalfundmedia.com; Online News Editor: Mark Kitchen, [email protected] Deputy Online News Editor: Leah Cunningham, [email protected] Graphic Design: Siobhan Brownlow, [email protected] Sales Managers: Simon Broch, [email protected]; Malcolm Dunn, [email protected] Marketing Administrator: Marion Fullerton, [email protected] Head of Events: Katie Gopal, [email protected] Head of Awards Research: Mary Gopalan, [email protected] Chief Operating Officer: Oliver Bradley, [email protected] Chairman & Publisher: Sunil Gopalan, [email protected] Photographs: iStock; NYC & Company Published by: GFM Ltd, Floor One, Liberation Station, St Helier, Jersey JE2 3AS, Channel Islands Tel: +44 (0)1534 719780 Website: www.globalfundmedia.com ©Copyright 2015 GFM Ltd. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher. Investment Warning: The information provided in this publication should not form the sole basis of any investment decision. No investment decision should be made in relation to any of the information provided other than on the advice of a professional financial advisor. Past performance is no guarantee of future results. The value and income derived from investments can go down as well as up.

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How to make risk management more strategic By James Williams

One aspect to operational risk, which can “Operational risk management is something have a meaningful impact on performance, I always think about holistically; market, not to mention the integrity of the manager, liquidity, credit, operating and residual ,” is valuations. According to Deutsche Bank’s says Andrew Kandiew, Head of Operational Global Prime Finance group’s third annual Due Diligence at K2 Advisors, a leading fund Operational Due Diligence Survey, asset of hedge funds manager with USD10.3 billion valuation is in sharp focus for 38 per cent of in AUM. “This is risk management but one investors surveyed. Unilaterally, respondents that focuses more on qualitative aspects said they would review a fund’s valuation when evaluating the manager. policy during their ODD review whilst 78 per “Operational due diligence has become cent stated they would verify the valuation much more important post-08. Your ODD procedure during the on-site review. has got to have teeth and you’ve got to Asset valuation is inherently a function of demonstrate that it works. In terms of pricing the quality of data inputs. A SunGard survey and valuation, we will always seek to fully last year revealed just how important risk understand the investment strategy of any pricing is in the front office. Some 20 per manager; what they are trading and the cent of respondents attributed its importance instruments they hold in their portfolio. From to calculating credit valuation agreements there, we consider a manager’s pricing and (CVAs), 31.8 per cent to initial . We look at a host of operating requirements and 22.7 per cent to funding risk factors, and valuation is a key one. valuation adjustments and other funding “For example, we will look at whether a costs. Admittedly, this survey centred on manager has written valuation procedures banking entities but the issues apply equally that are germane to the strategy, as well to the industry. as a governance structure around the

HEDGE FUND RISK Hedgeweek Special Report Oct 2015 www.hedgeweek.com | 3 OVERVIEW valuation process i.e. does the manager “Operational risk management have a valuation committee? What is its composition? How are issues escalated? is something I always think Who are the people and infrastructure used about holistically; market, to support pricing and valuation? Are there liquidity, credit, operating and clear segregation of duties within the firm?” explains Kandiew. residual risks.” Such is the importance of operational Andrew Kandiew, K2 Advisors risk that strategically, K2 Advisors uses a completely independent approach whereby Kandiew does not report to the head of research. Research is charged with Take the Black-Scholes model for pricing the responsibility of looking for potential options as an example. One of the greatest investment managers and whilst there is a financial innovations ever, the assumptions spirit of collaboration within K2 Advisors, “my used in Black-Scholes are actually very role is independent of the research team. I simple and as such bear no resemblance to have a veto that I can exercise, and at times reality. This has led to Black-Scholes being do, when they recommend managers to applied back to front. invest with,” adds Kandiew. Instead of saying, “I think this is the volatility and therefore this is the price of the Model risk option”, SunGard APT uses the market to The accuracy of a manager’s valuations price the option and then works backwards ultimately depends on the quality of data to determine what the volatilty should be. inputs but it also depends on the valuation This is referred to as implied volatility. model being used. Valuation sounds like it “We have to make sure that we can should be precise but valuation models rely justify the implied when clients look at on using different assumptions such that it their portfolio. We believe in Black-Scholes, can only ever be an approximation. There precisely because we use it backwards not is some acknowledgement that mark-to- forwards; which would otherwise create market and mark-to-model techniques do not model risk,” explains Wormald. necessarily provide accurate numbers. One important development to help The level of uncertainty that comes with improve risk management is to integrate using a valuation model is known as model liquidity modelling into risk models. This is risk and it is something that risk managers something that SunGard has recently rolled have become far more focused on recently. out within APT. Knowing the limitations of a model has been When there are shocks to prices there an important step change. are often shocks to liquidity as well and A big part of operational risk could it becomes harder to close out positions, therefore stem from valuations. To make this or indeed put on positions. That ability to more strategic, risk managers should review combine price and liquidity shocks in the their models and the implicit assumptions model has therefore become critical. that underpin those models on a periodic “The key is to provide intiution rather basis; stress testing, sensitivity analysis etc. Dr Lawrence Wormald, COO than just an arbitrary number. A few years “We service a number of private debt and head of research, SunGard ago people came up with liquidity-adjusted strategies and when it comes to doing VaR, which was always a bit bigger than valuations you have to do a great deal the ordinary VaR. But why? Few could of sophisticated credit analysis (model understand it. We are trying to improve on behaviours, weighting assignments etc),” that by using a factor model for liquidity says Alan Picone, global head of risk risk. It is already being consumed by five or consulting and infrastructure at Duff & six of our global clients in APT. It satisfies Phelps’ Kinetic Partners division. the regulator but more importantly it gives Model risk is something that Dr Lawrence managers extra information to make more Wormald, COO and head of research, informed decisions,” SunGard APT, gets asked about a lot. confirms Wormald. 7

HEDGE FUND RISK Hedgeweek Special Report Oct 2015 www.hedgeweek.com | 4 KINETIC PARTNERS AIFMD and the mutation of risk management Interview with Alan Picone

Risk managers are making a more conscious understanding the processes and risks of effort to not only understand the virtues, the brokers, custodians, administrators and but also the limitations, to risk models as any other companies that support a hedge they adjust to life under greater regulatory fund’s operations. scrutiny, in particular the AIFM Directive “When you look at risk management in Europe. from this perspective, and you add to that Indeed, such is the impact of regulation such things as liquidity management rules, that it has in effect transformed the risk rules under the Directive, management function from something you can see that the risk management that was previously confined to portfolio function has become very far reaching as management into something altogether Alan Picone, managing opposed to what it was in the past,” says more holistic. director at Duff & Phelps’ Picone, who adds: “Another key observation Alan Picone is a managing director at Kinetic Partners division is that risk management in the past was Duff & Phelps’ Kinetic Partners division. viewed as an ex post control, meaning He has a broad range of expertise on risk that decisions were taken and then risk management and given that Kinetic Partners management was applied afterwards to was one of the first firms to obtain a third measure the potential impact of those party AIFM license in Luxembourg, Picone is trading decisions. well versed in understanding the changing “The AIFMD changes this fundamentally, dynamics of risk management that hedge such that ex ante risk management becomes funds now face under the Directive. critical. We see more interaction of the risk “We are acting as an AIFM on behalf of management function with the portfolio external hedge fund managers to help them management function; these have always been meet the risk management and compliance embedded to some extent in hedge funds challenges of AIFMD and as such are well but not to the degree that risk management placed to see what the impact of AIFMD becomes, so to say, intrusive. It requires a is having on managers. One of the things number of critical tasks such as risk attribution, that we are seeing is a fairly profound margin-at-risk impact and so on.” mutation of the risk management function,” In other words, ex ante risk has become says Picone. more systematic. Some of the larger The upshot to AIFMD is that managers hedge funds have long had in place robust are increasingly relying on more systems, processes to embed risk management as processes and procedures, and indeed much as possible into the portfolio decision staff, to remain compliant. The role of making process at the pre-trade level. Under risk management must now embrace all AIFMD, all managers are required to adopt dimensions of the fund’s value chain: this mindset; it is a cultural shift. portfolio risk management, operational A good example of where ex ante risk risk management, as well as management has become a major focus the management of risks that have been would be systematic CTAs. Given that these delegated to third party providers; this is the strategies employ sophisticated trading risk oversight function, which has become algorithms to detect market signals and put an integral part of a manager’s aggregate on positions in the portfolio, there is less risk framework. involvement by risk teams in the decision As Picone points out, this requires making process. However, where risk teams

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get more deeply involved is in validating the It is a fantastic challenge. risk models used by the algorithms. “Risk managers know that whenever they “I’m generalising here but what we’ve develop a risk model it is only ever likely to seen is that the role of risk managers in describe some element of reality, but not the terms of validating trading models has full reality. In the past, this acknowledgement become much more important. There is more of the limitations to risk models was not caution being applied to test the resilience of communicated; the classic example being trading models,” says Picone. Black-Scholes. When you look at the Caution is no bad thing when it comes to underlying assumptions they are completely risk management. Nobody is naïve enough outside the realm of empirical reality and to expect risk models to provide a crystal you have to wonder why this model has ball into future volatility and whilst AIFMD been used for so long. The assumptions has amplified the risk function, expectations have nothing to do with reality. The reason need to be kept in check. One element it has been used so extensively is precisely of this caution is by being more attuned because the model is simple. to the limits of risk models; that is to say, “My point is that there is now a more understanding the qualitative risks and trying conscious attitude towards acknowledging to avoid being reliant on models that are too not only the virtues but also the limits of simplistic to measure risk. risk models. Risk managers are increasingly “The Black-Scholes formula for pricing mindful when using models to understand, options was a major breakthrough but it was first and foremost, what they don’t do rather qualitative and mathematically driven and than what they actually do. And that’s an as such it was viewed as a Golden Rule. important paradigm shift,” posits Picone. It became almost Holy Grail-like,” remarks In some respects, the AIFMD has helped Picone. “All risk modelers now understand push forward the cultural adoption of risk that it is far from reality. Models come management and broaden its application. with limitations as they try to describe the Model risk is an important evolution precisely complexities of reality. because risk managers do not want to get “Whereas in the past, such models would blinded by the VaR number; nobody wants have been seen as the ultimate weapon to another Long Term Capital Management describing reality, today they are viewed more event to occur. as a starting point. Models are more prone “There’s now a need to more accurately to be reviewed and critiqued. I think risk capture the specific features of financial managers are more inclined to understand markets. If you want to benefit from market the limitations of their models, and the risks inefficiencies you need to look at numerous attached, as opposed to believing that their factors and lots of data. For quantitative model is a fair description of the world. This and systematic strategies, the detection is a change in philosophy. Risk management of inefficiencies and the decision making has to work within limits and I think everyone programs are becoming increasingly now recognises those limits; risk managers influenced by risk managers. are applying more rigorous governance to “For other strategies, such as equity long/ their risk models, which you wouldn’t have , risk managers will have a growing seen 10 or 20 years ago.” influence in guiding the portfolio manager(s) Regardless of whether the risk model is during the investment process. They will ex ante or ex post, the implied assumptions provide additional insights and tools to help mean that it can only ever produce a risk the front office with respect to risk allocation, estimate. In that sense, risk management risk attribution etc. Portfolio managers is like trying to predict the weather; some want to better understand the risk budget,” may say it is even harder, given the true concludes Picone. complexity of financial markets. Risk With greater scrutiny of the risk numbers managers are required to somehow quantify and a willingness to question the limitations the level of risk the fund portfolio is exposed of risk models, hedge funds are working to, without having a complete understanding harder than ever to operate safely in today’s of the nature of the market. financial markets. n

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4 Protect yourself from failure of “There are a lot of levers that imagination At SkyBridge Capital, managing risk has go in to managing risk. We always been strategic. It has put significant take a holistic approach to risk effort into integrating risk management into management, and continually portfolio construction to ensure that time and again, the investment portfolio minimises enhance and broaden our losses on the downside and maximises analytical capabilities to aid gains on the upside. Applying a disciplined approach has allowed the SkyBridge flagship our portfolio management fund to outperform in every market sell-off in generating desired risk- over recent times. adjusted returns.” “There are a lot of levers that go in to managing risk. We take a holistic approach Tatiana Segal, SkyBridge to risk management, and continually enhance and broaden our analytical capabilities to the empirical data, yet forward looking that aid our portfolio management in generating consider a wide spectrum of possibilities. It’s desired risk-adjusted returns. We are always a delicate balance.” adding new tools to our risk management One of the ways that Duff & Phelps’ tool kit,” explains SkyBridge Partner and Kinetic Partners division is helping managers Head of Risk Management, Tatiana Segal. to improve their risk management activities, SkyBridge’s approach to managing risk particularly in response to market regulations is to not only rely on looking in the rear- and reporting obligations under the AIFMD, view mirror but to be as forward-looking as is to provide an advisory service as part of a possible. This is achieved by using Imagine wider AIFM solution. Software to provide position-level detail within This involves performing a number of the portfolio in tandem with proprietary tools. model validations – be it algorithms that are “Broadly speaking, we focus on used by systematic CTAs, be it risk systems embedded alpha, while our will fluctuate or valuation models. depending on our conviction, with historical “We have a proprietary solution for risk ranges around -0.2 to +0.5. Our approach reporting; it is a full fledged risk management is to continually analyse multiple scenarios and risk measurement solution. Typically, of how the risk/reward can play out so hedge fund managers can send us their that we stay best positioned to extract our portfolio which we process in our system and targeted compensation, over a full market we produce for them the Annex IV report. cycle, for each unit of risk that we take. The It captures everything from sensitivities to Beta expression will change accordingly,” conditional VaR, and so on. says Segal. “This is ideal for managers who want the “We test the portfolio using both historical report first thing in the morning to analyse. and hypothetical scenarios, and while we Typically this is being done on a daily basis,” continually add new scenarios relevant to confirms Picone. the current market environment, we remain Any time a hedge fund manager uses risk mindful of what a truly worst case might systems, there is often a disconnect between be. Although we remain constructive, it’s the front office traders and the middle office important to not grow complacent. That is team, which might be generating a daily why we focus on modeling portfolio liquidity report on risk that the investment decision assuming multiples of 2008 redemption makers do not agree with. levels, the highest-ever redemptions we have To make risk more strategic, therefore, seen since inception. requires a system that provides intuition “I’ve heard it said that one of the main as well as an enterprise-level capability. By problems with risk management frameworks doing so, managers are able to tell a more pre-crisis was a failure of imagination. We coherent story about how they manage risk, are trying to learn from that. We built our thereby enhancing their reputation and asset risk management platform to be rooted in raising capabilities. 10

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This advertisement is for information purposes only and is designed to serve as a general overview regarding the services of Deutsche Bank AG, any of its branches and affiliates. The general description in this advertisement relates to services offered by Global Transaction Banking of Deutsche Bank AG, any of its branches and affiliates to customers as of September which may be subject to change in the future. This advertisement and the general description of the services are in their nature only illustrative, do neither explicitly nor implicitly make an offer and therefore do not contain or cannot result in any contractual or non-contractual obligation or liability of Deutsche Bank AG, any of its branches or affiliates. Deutsche Bank AG is authorised under German Banking Law (competent authorities: European Central Bank and German Federal Financial Supervisory Authority (BaFin)) and, in the United Kingdom, by the Prudential Regulation Authority. It is subject to supervision by the European Central Bank and the BaFin, and to limited supervision in the United Kingdom by the Prudential Regulation Authority and the Financial Conduct Authority. Details about the extent of our authorisation and supervision by these authorities are available on request. Copyright © September 2015 Deutsche Bank AG. All rights reserved DEUTSCHE BANK ODD comes under the microscope Interview with Kristin Castellanos

Operational Due Diligence (ODD) has investors who allocate funds to alternative become increasingly important across the investment managers. “As competition is alternative investment industry and more fierce when attracting investments from resources and attention are being placed allocators, alternative investment managers on this function. This was one of the must be prepared to pass rigorous due main findings from a session on ODD at diligence standards, particularly in ODD,” the recent Global Alternative Investment says Castellanos. Management (GAIM) Ops Conference in the While the panel called for more Cayman Islands. background checks and transparency, among Kristin Castellanos of Deutsche Bank’s other things, cash controls at hedge funds Head of Regulatory Fund Services within Kristin Castellanos, Head of were considered to be among the biggest its Institutional Cash & Securities Services, Regulatory Fund Services at risks. Explains Castellanos: “Although the moderated a panel on the subject of ODD Deutsche Bank industry has come a long way in terms of and how the process has changed over the operating controls, there are still many firms past decade. She says: “10 years ago, most that permit manual wire payments instead of ODD was conducted around account policies using more secure electronic methods. There and procedures. But as fund accounting are some compensating controls that could risks have reduced, compliance and IT risks be quick wins, such as having compliance have multiplied.” staff perform testing of wires to ensure they Today, there is more dedicated focus – are being completed in accordance with the and at a higher level – on ODD meetings policies in place.” accompanied by greater transparency. Some Castellanos concludes by saying that there 95 per cent of fund managers now provide is broad agreement that ODD will continue transparency reports, a marked contrast from to evolve in the coming years to meet the the past. ODD teams are also actively involved expectations of institutional investors: “At in counterparty discussions whereas in the Deutsche Bank, we will keep ahead of market past, these were handled almost exclusively by developments in order to work with our investment due diligence teams. clients to try to help them navigate today’s Within ODD activities, the most time- complex and challenging landscape.” n consuming is the constant review of controls and processes employed by the fund through This document is for information purposes only and is designed to serve as a general its main outsourced service providers. Almost overview regarding the services of Deutsche Bank AG, any of its branches and affiliates. equally lengthy is the behavioral analysis The general description in this (presentation, factsheet, brochure, newsletter, document) relates to services offered by Global Transaction Banking of Deutsche Bank AG, any of employees and principals of the fund of its branches and affiliates to customers as of (Month Year), which may be subject manager and understanding the custody and to change in the future. This (presentation, factsheet, brochure, newsletter, document) security of a fund’s assets. and the general description of the services are in their nature only illustrative, do neither explicitly nor implicitly make an offer and therefore do not contain or cannot result in What are ODD teams’ chief concerns? any contractual or non-contractual obligation or liability of Deutsche Bank AG, any of its At the top of the list is ensuring the budget branches or affiliates. is in place to maintain operational controls. Deutsche Bank AG is authorised under German Banking Law (competent authority: German Banking Supervision Authority (BaFin)) and, in the United Kingdom, by the Other important issues include the shadow Prudential Regulation Authority. It is subject to supervision by the European Central Bank accounting of the administrator and the and by BaFin, Germany’s Federal Financial Supervisory Authority, and is subject to limited segregation of duties between traders and regulation in the United Kingdom by the Prudential Regulation Authority and Financial internal accounting. Conduct Authority. Details about the extent of our authorisation and regulation by the Prudential Regulation Authority and regulation by the Financial Conduct Authority are Castellanos adds that the drivers behind available on request. all the changes around ODD are the Copyright© July 2015 Deutsche Bank AG. All rights reserved.

HEDGE FUND RISK Hedgeweek Special Report Oct 2015 www.hedgeweek.com | 9 OVERVIEW

7 “We think we can help our clients achieve In my opinion, stress testing that because we give them a comprehensive and coherent model in APT. Coherent in the and sensitivity are two sense that a single risk model is designed important concepts that are to provide coverage across all major asset becoming more important classes. It’s also intuitive because APT is a factor model. It’s not just based on time than VaR.” series and pure statistical approaches,” Dr Ken Akoundi, ASPN explains Wormald. Whatever the story is, you need to have a system that people internally buy-in to each other, share ideas, and basically get a as well as externally when speaking to clearer handle on the risk and performance prospective investors. That’s when risk can attribution of managers in their portfolio. become a part of the strategic vision of an The reason why this is enabling investors asset management business. to become more strategic is because ASPN Having a risk system that makes traders provides them with a central repository to feel that they are getting good information is collect and store data. In Akoundi’s view, important. institutions are less interested in granular “Investors gain intuition by thinking position-level data. The hurdle many are about risk in factor terms. Most investment still trying to overcome is getting all of their professionals believe that there are different manager data in one place. factors driving the market; it might be interest “They might have a document sharing rates, commodities pricing, a restructuring system, a performance measurement system, story within a market segment. If you can a factor model system; that’s three systems relate risk to those factors that are driving already. With ASPN they have one system the market, then people believe that the with everything in one place. They’ve got risk numbers you use make sense. They their data in good order on the long only side might then have the confidence to take on but when it comes to hedge funds it’s still a more exposure because they have a better complete mess for most institutional investors. understanding, and potentially boost returns. “For many investors, extracting information “If you don’t have a factor model you from monthly newsletters, summaries and won’t be able to get insights from asking the putting it all into a spreadsheet is timely. system, ‘Tell me about my China exposure’, What we can do is create a data map or ‘Tell me about my oil exposure’. For a for every manager letter. The day after a straightforward European long/short equity manager releases their monthly letter, it’s in strategy, the implied exposure you have to the ASPN system ready for the investor to commodities or export companies that do review,” says Akoundi. business in China will be a and a When asked whether the collaboration potential return driver. If you’re not capturing capabilities of ASPN could change the way that with your risk system, it’s impossible to that institutional investors approach risk be strategic,” stresses Wormald. management, Akoundi responds: “Overall, I don’t think using ASPN will change investors’ The wisdom of the crowd risk appetite. They just want the ability to The Alternative Share Private Network (‘ASPN use risk tools that will tell them what will Solutions’) is a comprehensive front, middle, happen if something goes wrong. In my and back office solution designed to empower opinion, stress testing and sensitivity are institutional investors to build, execute and two important concepts that are becoming monitor multi-manager hedge fund portfolios. more important than VaR. It’s not only Dr Ken Akoundi, one of the founders of knowing how a 5 standard deviation left RiskMetrics and who joined ASPN last year, tail event would impact the portfolio, but explains that the system has been built on the also a 4 and 3 standard deviation event, a basis of the ‘wisdom of the crowd’. median standard deviation, and perhaps a 5 As such, ASPN is a solution designed to standard deviation right tail event. Users can help institutional investors collaborate with do that visually in ASPN.” n

HEDGE FUND RISK Hedgeweek Special Report Oct 2015 www.hedgeweek.com | 10 WELLS FARGO GLOBAL FUND SERVICES A new view into hedge fund operational risk By Chris Kundro

There are many professionals, both internal collateral management, asset servicing and and external to a fund manager, who play P&L calculations, an important role in controlling a fund’s • Real time monitoring of fund accounting operational infrastructure and mitigating a activities such as NAV calculation and fund’s operational risk. COOs, CFOs, and financial statement processing, CCOs manage the functions necessary to • Real time monitoring of investor activities support a hedge fund, while fund directors, such as subscription/redemption and capital auditors, and operational risk analysts ensure call/distribution, KYC/AML, and investor that a hedge fund’s infrastructure is sound accounting and servicing activities, and secure. • Counterparty risk information and However, unlike portfolio managers Chris Kundro, Senior Vice information related to the operational and traders that have always had portfolio President, Head of Wells Fargo effectiveness of counterparties such as Global Fund Services management, trade order management, and prime brokers, other systems to leverage, operational professionals • On-line access to operations, accounting, investor and have historically lacked sophisticated or comprehensive regulatory information and reporting, including report systems for managing and analysing a fund’s operations, writer capabilities for generating customised reports. accounting, compliance, and investor servicing At Wells Fargo Global Fund Services, we took an related functions. exception-based approach in designing our Operational Consequently, operational management of a fund has Management System for both hedge fund and private been inherently challenging due to a lack of complete equity managers, which is called Fund View. While and timely operational information. Furthermore taking our clients and internal teams can utilise our system that information, analysing it, and identifying systemic to access and design comprehensive middle and issues has been virtually impossible or at the very least back office operations, fund accounting, and investor manually intensive. However solutions to these problems and regulatory related reports, Fund View, like similar are quickly evolving and in turn both the operational applications, provides real-time dashboards with key management and due diligence of hedge funds are performance indicators that highlight current and becoming more sophisticated and comprehensive. potential operational issues. These issues include: Best practice in hedge fund operational management • Transaction capture errors now dictates the use of a new category of applications • Position and cash breaks that we call “Operational Management Systems”. • Unconfirmed and failed transactions Operational Management Systems are not processing • Counterparty operational issues or accounting systems but workstations that provide a • Pricing exceptions and variances window into the post trade activities of a fund. These • Delinquent activities related to critical processes (e.g., workstations provide the information necessary to NAV production) monitor and measure operational activities, analyse • Non-compliant investors/transactions (KYC/AML, and mitigate operational risk, and ultimately ensure that FACTA) both internally supported and outsourced functions are • Unplanned counterparty financial and operational performing efficiently and effectively. exposure. Operational Management Systems vary in design and While Operational Management Systems are still in their function; however these systems provide some or all of infancy relative to their more mature front office siblings, the following functions and information: they are growing and evolving quickly. However, even in • Real-time monitoring of middle and back office their current stage of development, they finally provide operations activities such as trade capture, securities/ the critical automation and information that COOs and cash reconciliation, confirmation, settlement, cash and other fund professionals have long awaited. n

HEDGE FUND RISK Hedgeweek Special Report Oct 2015 www.hedgeweek.com | 11 OVERVIEWINDUSTRY

Will regulation help or hinder derivatives risk management? By James Williams

Managing derivatives risk in the portfolio is different models for pricing and margining. a demanding task at the best of times. But Portfolio managers using more than one CCP as global regulators make inroads to drive arrangement need to factor this into their risk transparency in OTC markets, managers management and decision making. find themselves having to file detailed risk “The clearing houses are also using positions under CFTC regulations in the US, different ways to build curves and volatility EMIR reporting in Europe, not to mention the surfaces which directly impacts collateral unnecessarily dense Annex IV report under valuation, which can further impact price AIFMD. and risk. A swap position in TFG can have Quite what regulators hope to gain by a different value depending on where it is getting such voluminous data remains to cleared and what the customer requires,” be seen. Still, managers must comply. OTC says Martin Toyer, Chief Technology Officer derivatives are increasingly being traded on at TFG Financial Systems. Swap Execution Facilities (SEFs) under Dodd- “We have one client who wants to match Frank, with exchanges such as CME Group the clearer’s price so that they aren’t getting rolling out products such as the Deliverable a different price when they trade. To support Swap Future, a standardised contract that this has required development work for illustrates a move towards swap “futurisation” capturing trades from SEFs to dealing with and a move away from the opaque bilateral different netting and different valuation OTC trade environment, which some consider models – thereby increasing complexity.” too systematically risky. As Georgia Brewster, Sales Manager at The migration to centralised clearing TFG points out: “We have tried to enable for OTC derivatives has created numerous clients to lead the way on how they would centralised clearing parties (CCPs). One issue like their portfolio to be managed in this new is that different clearing houses are using environment. We’re giving them the flexibility

HEDGE FUND RISK Hedgeweek Special Report Oct 2015 www.hedgeweek.com | 12 INDUSTRY with the software to let them contribute a “We have tried to enable valuation from the clearer, for example.” In Brewster’s view, it’s too early to clients to lead the way on know whether regulation is going to make how they would like their derivatives risk management any easier or portfolio to be managed in not. The good news, however, is that some firms are developing solutions to make this new environment.” managers’ lives easier, specifically with Georgia Brewster, TFG Financial respect to margining. Systems OpenGamma is a leading provider of OTC market structure solutions. It has provider, Derivitec, whose central philosophy worked in collaboration with OTC derivatives is to provide its clients with validated risk market participants to build an open source management reporting. model to calculate the margin on bilateral At the heart of the Derivitec model is the OTC trades. The solution will use the final ability to analyse a portfolio of derivatives Standard Initial Margin Methodology (‘SIMM’) exclusively via the web, with no need for developed by ISDA and will be made users to go through the time and ongoing available to market participants on costs of a system install. This is about Github.com, an open source environment. leveraging the cloud to optimise portfolio risk This is an important development as the management. OTC markets adjust to regulation because as Derivitec generates standard risk reports highlighted above regarding clearing houses, that include all the usual one the derivatives industry needs to instill associates with risk, as well as some degree of standardisation. Otherwise stress tests and will soon be providing risk reporting and remaining compliant will historical and parametric (Variance/ become an impossible exercise. Covariance) VaR. What is especially powerful, With OpenGamma’s SIMM solution, however, is that end-users are able to drill derivatives traders will have access to right down into the analytics from which the source code for margining for the first time headline numbers derive. and allow them to avail of an independent, This is particularly important for investors verifiable calculation framework. It’s a loose and is something that start-up hedge funds, analogy, but one could think of this as in particular, can use as a real point of being similar to the creation of the OPERA differentiation. They could, for example, invite reporting standard that provides managers prospective investors on to the platform so with a common reporting framework to use that they themselves can check the numbers, with their investors. look at the underlying risk metrics within the “With capital scarce, financial firms are report, and get a deeper understanding of more focused than ever on developing high- that manager’s approach to trading risk. value, proprietary innovations rather than Discussing the reporting capabilities, recreating industry-standard methodologies,” George Kaye, CEO of Derivitec says that said Mas Nakachi, CEO of OpenGamma the advantage of using a third party vendor back in March this year. “That’s why we’re is that “we implement the solution for working with the industry to streamline and everybody so the consistency checks are democratise the development of market much more stringent. structure solutions, which also fundamentally “Whether it’s looking at the Greeks, reduces operational and shock scenarios, VaR, our reports can help through the inherent transparency of open risk managers both in sell-side and buy- source code. We believe the future of OTC side institutions. Organisations will have a market structure will be driven by the need preferred PMS but we can integrate quite for transparency and will therefore be based easily to give them the ability to dive deeper on open standards.” into the risk numbers. Given risk can be One firm that has stepped in to the breach exposed in numerous ways, it takes the to make it easier for derivatives traders pressure off managers. We are basically to generate risk reports is cloud-based filling a gap where clients want to produce 16

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PORTFOLIOSCIENCE A fully hosted and customisable risk solution Interview with Ittai Korin, PortfolioScience

The RiskAPI service, developed by is that it is offered “on demand”. Once a PortfolioScience, is a fully hosted and trade is placed in a manager’s execution customisable risk solution that integrates management system, a request is seamlessly with existing applications and automatically sent to RiskAPI, at which programming frameworks to generate risk point all the risk calculations are instantly calculations for multi-asset, multi-currency populated and conveyed to the end-user. portfolios and individual positions. It is “Our philosophy is to provide clients with available as both an Enterprise software API the same level of control that they would and an Excel Add-In. have if they were to build an in-house risk Rather than being a risk calculator, per se, solution from scratch. Our hosted solution it is a complete end-to-end solution. Ittai Korin, President, does exactly that, without the overhead of “Our system has all the underlying data, PortfolioScience the manager having to build it and maintain it and all the necessary analytics, connections going forward. Every day there are changes and external data feeds within the to valuations, pricing etc. That ongoing infrastructure; everything needed to generate monitoring and management can use up a a full spectrum of risk calculations,” explains tremendous amount of bandwidth. Clients Ittai Korin, President, PortfolioScience. “If they can offload that to us and still maintain a want, managers can come to us with nothing high level of control,” says Korin. more than a description of their portfolio.” Broadly speaking, RiskAPI provides dynamic multi-model VaR, valuation, and Short integration time stress-testing capabilities, whereby users can The fact that the solution is delivered as an select and specify a variety of inputs. API is quite unique in the marketplace. “This provides a more sophisticated Korin notes that one of the biggest way to interact with our system. We have disadvantages that clients of its competitors larger clients with in-house development face is that it can often take several months teams using this solution to build their before they see any system output due to own enterprise risk systems. Larger funds, the time it takes to integrate with in-house for example, will have an internal data systems. “Because of the lightweight nature warehouse. They use RiskAPI Enterprise of our API interface, customers can get up in conjunction with their data warehouse, and running and start generating results in a which contains portfolio position data, to run matter of days,” says Korin. risk calculations and render reports when needed,” explains Korin. High degree of customisation PortfolioScience also has connections to In addition, because it is an API and is highly various data vendors covering different assets customisable, users are able to generate and markets to help ensure that the quality of results according to how they work, and how data produces as accurate a picture of risk, at they view the world. The idea is that users any given moment, as possible. are not getting a standard off-the-shelf risk “We know how important data is to risk report that somebody else has built. They management. Ours is a very thorough and have full control over what parameters to extensive database. Managers are getting use, which calculations to perform, and how accurate risk calculations generated off the to present the data. back of the data we have at our disposal,” Another important feature of RiskAPI concludes Korin. n

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13 certain risk reports from their existing system “Whether it’s looking at the vendors, but are dealing with much longer implementation lag times. We can overcome Greeks, shock scenarios, that,” says Kaye. VaR, our reports can This is one of the benefits of using a help risk managers both powerful cloud-based risk engine. Kaye says that people are speaking to Derivitec in sell-side and buy-side precisely because it uses the cloud. institutions.” “For example, we are talking with one George Kaye, Derivitec prime broker who likes the fact that we operate in the cloud because it allows them to share information immediately with sensitivity across different parts of the their clients, and in turn allows clients to portfolio, the degree to which correlation be responsible for booking their positions. is increasing or decreasing across There’s greater commonality to discuss strategies, etc. prices with the PB, and the fact that there is “We look at risk factors such as leverage, no software to download makes it a good fit counterparty exposure, the degree to which for a lot of people,” explains Kaye. we see dislocations in the liquidity profile One of TFG’s objectives is to provide of the portfolio. Under Basel 3 and other risk numbers that are explainable and developing regulation, banks will have to be understandable. This means trying to make ever more cognisant of where they deploy scenario generation within the system as capital going forward. model-independent as possible. “As a hedge fund allocator, it will become “Users can define the ‘What if…’ event a key issue for us to ensure that the in terms of market shocks, or define it by manager’s perception of liquidity matches how much an index or curve were to move up with the actual liquidity that their banking and the market were also to move with it counterparty can provide. Understanding in a correlated manner. You can also see the liquidity profile relationship between what would happen to the portfolio if certain the manager and the prime broker is going historical events were to be repeated. to be vital when we move from a benign “To present these numbers we use what market environment to a more volatile and are known as Mastermind sheets. They challenged one,” says McCaffery. have Excel-like functionality that allows you Aberdeen is in the rather unique position to create a real-time monitor which sits on in that it is both an asset manager in its your desktop to monitor stress tests or factor own right, and also an asset allocator. In shifts. You can commingle multiple types that sense, the firm appreciates the minutiae of shocks and the numbers can be colour- of regulation. Its fixed income business, for coded depending on risk levels. example, has to comply with EMIR reporting “What we are seeing is clients requesting on the derivatives it trades. those risk numbers at different levels of “As allocators, what is key is understanding granularity using more complex shocks,” that the underlying managers meet the confirms Toyer. regulatory requirements and remain compliant. Andrew McCaffery is Global Head of There are potential costs of failing to Alternatives at Aberdeen Asset Management. accurately report that could potentially impact Aberdeen will have over USD30 billion a manager’s strategy,” comments McCaffery. in across its Asked whether the added transparency of alternatives platform once the acquisition OTC clearing under EMIR and Dodd-Frank of leading fund-of-hedge-funds manager could help or hinder Aberdeen in respect Arden Asset Management and FLAG to risk management, McCaffery raises an Capital Management, a PERE manager, is interesting point. Will managers benefit from completed. increased visability and transparency in the When it comes to risk management, way they trade derivatives or will they be McCaffery says that the team looks at at a disadvantage precisely because the everything from position risk concentration, opaqueness of the OTC derivatives markets 19

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Real-time risk and performance True multi-asset platform supporting: Support for complex derivatives FX Rates Automated trade processing Credit Investment Accounting Fixed Income Equities Flexibility and reliability Commodities

To discuss how TFG could help you react faster to market changes, add value to investors and ease your technology burden, visit www.tfgsystems.com to download a brochure, or call our sales team: New York +1 (646) 233-3266, London +44 (0) 20 3370 1780.

hfm_ad_oct_2015.indd 1 23/09/2015 13:03:42 TFG FINANCIAL SYSTEMS Delivering real-time risk that reflects the speed of the market Interview with Martin Toyer

The markets have experienced significant historical reporting and real‑time shadow volatility in the last few months. China’s NAV. It is a true front to back portfolio and decision to devalue its currency, the collapse risk management platform. of commodity prices and the uncertainty Risk management has grown in caused by global quantitative easing have importance and complexity since the all caused significant disruption to financial 2008 financial crash. Having a detailed markets. In August, all three major equity understanding of where is indices in the US suffered their biggest generated requires accurate/reconciled losses since 2011. positions, clean market data and user Hedge funds need to manage volatility flexibility in terms of pricing models, curve and to do that effectively requires a risk Martin Toyer, Chief Technology construction and scenario generation. Toyer management system that is real-time, user Officer at TFG Financial notes that because TFG is focused on all Systems driven and flexible enough to provide the these aspects it ensures that its clients have instant analysis that is required. the tools they need to navigate the most This is precisely what TFG Financial volatile markets. Systems provide. Offered as a cloud-based “There’s very little on the buy-side in solution, TFG delivers the only true real-time terms of proprietary valuations. We therefore solution for multi-asset class portfolios. The made the decision to build our own libraries core infrastructure was built to be massively to maximise performance, lower cost and scalable using low cost technology and provide the flexibility our clients demand. delivers the performance that today’s volatile Our analytics give users complete control markets demand. VaR, NAV and stress/ over which positions use which curves for scenario reporting is delivered real-time tick valuation. This customisation, combined by tick as markets are moving. with the speed of valuation and user driven “With increasing volatility, it has become real-time reporting, is unique to TFG,” more important to see the instantaneous explains Toyer. impact of any price moves in the portfolio’s There are two main elements to TFG’s assets. Portfolio managers can no longer software. The primary aspect provides real- afford to wait until the end of the day to time VaR, stress testing and P&L attribution see what the impact of a Federal Reserve at the strategy level, the underlying asset rate hike has had, for example,” says Martin level and the position level. The secondary Toyer, Chief Technology Officer at TFG. aspect, says Toyer, allows users to capture As well as being a real-time position and daily risk/p&l data, which can then be risk management system, TFG provides stored in a data warehouse to run historical full middle/back office capabilities which analyses for portfolio back-testing and were designed to maximise the level regulatory reporting. of automation and minimise headcount Asset coverage includes both cash and costs. This covers full STP capabilities derivative products for FX, fixed income, for trade workflows, cash management, equity, interest rates, commodities, credit reconciliation, collateral management, and inflation. n

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16 has, up until now, been a cornerstone of “As allocators, what is key how they generate alpha in the strategy? “There’s no easy answer to that at is understanding that the this stage as people are still adjusting underlying managers meet to regulation. The challenge for us is to the regulatory requirements understand the dynamics of derivatives regulation and moreover, be comfortable and remain compliant.” knowing that the underlying manager is Andrew McCaffery, Aberdeen Asset well placed to understand it. How is it Management changing the way they operate as OTC derivatives starts to move towards more designed such that it can cope with the extra of an exchange-traded environment? We demands of regulation. want to be clear that we understand how “From a usability perspective, if a risk the manager might be impacted,” explains manager or a trader comes to us and says, McCaffery. ‘I want to be able to run risk analytics on One potential unintended consequence equity options’, we have to provide a full of Basel 3 regulation is that it could actually picture of their exposure. It’s not therefore a push fund managers to trade more synthetic case of reacting to regulation and thinking, derivatives such as equity swaps as these ‘Right, we’d better add greater capability for contracts reduce the impact on a prime our clients’. The fact is, we have to do that broker’s balance sheet. anyway, even if there was no regulation. Equity swaps are notoriously complex so “What drives our product development having a common platform where people is the demands of our clients; does our can deep dive into the details of a trade and system functionality help them to better get comfort that the price and risk is correct, understand their risk exposure in a given is clearly an advantage. asset class? We don’t get too caught up “When it comes to understanding the in what regulators are saying. That is why minutiae of a synthetic trade it’s going to whenever we release something it is always be a lot easier using a system like Derivitec very detailed and robust from an analytical than passing spreadsheets around,” standpoint,” states Korin. suggests Kaye. That said, PortfolioScience is seeing more McCaffery notes that synthetic equities demand for real-time risk coverage from sell- usage is probably increasing at the margins side institutions. Whereas previously they might because of higher financing costs that only have looked at one level of output, now managers are facing to trade physical stocks. they are asking what other models they should “There’s a price to pay for going down be looking at in parallel; i.e. not just one type the synthetic and structured products route, of volatility, not just one type of stress-test, however. It comes down to the sophistication not just looking at the top five positions in the of a manager’s pricing versus the investment portfolio but looking at everything. bank they are trading with. Under stress, “They are coming to us and asking what is the cost impact going to be? How how they can get complete visability into will it change the liquidity profile? Managers everything that passes through their desk. who are well experienced at trading That’s definitely a big change in mindset. derivatives might see it as an opportunity Maybe it’s driven by regulation but it will but they need to understand what the almost certainly also be driven by not incremental benefits will be from a cost and wanting to lose money,” concludes Korin. liquidity perspective under different market Gaining greater insights into derivatives risk scenarios – not knowing this could seriously and using standard models for calculating impact the performance of the strategy,” initial margin will certainly help managers warns McCaffery. improve their risk processes under evolving Ittai Korin is the President of regulation. However, whether the transparency PortfolioScience in New York. The firm’s of OTC markets will dampen the ability for RiskAPI service is a fully hosted and managers to generate alpha is the USD64,000 customisable risk solution and has been question. Only time will tell… n

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