Regulators are asking a lot of questions of fund managers, many of them impertinent in both senses of that word. Ostensibly, the answers will enable them to deliver greater stability in financial markets, but the absurdity of this ambition is already becoming apparent.
There are many reasons to resent regulatory reporting requirements. But one that fund managers feel most keenly is that the whole exercise is pointless. It is not necessary to agree that regulatory reporting is nothing but the information fallacy writ large to wonder whether regulators have the time and expertise not to drown in the deluge of information they are now requesting. But it is worth remembering the warning of Friedrich Hayek that any attempt to control human interactions through the marketplace through deliberate arrangements based on the commissioning and study of information are factually as well as logically impossible. The most generous interpretation of regulatory reporting is that elected politicians felt they had to be seen to be doing something, even if the gesture was worse than futile, while regulators themselves welcomed the opportunity to secure larger budgets and payrolls.
Fund managers, meanwhile, must live with the consequences of these deliberate mistakes. They must collate, compile and submit data through Form PF and Form CPO-PQR to the Securities and Exchange Commission (SEC) and the National Futures Association (NFA) respectively; report details of exchange traded derivatives (ETDs) and over-the-counter (OTC) derivatives to trade repositories as mandated under the European Market Infrastructure Regulation (EMIR); report OTC derivatives trades to swap data repositories (SDRs) in the United States in accordance with the Dodd Frank Act; and supply a completed Annex IV report to European regulators, courtesy of the Alternative Investment Fund Managers Directive (AIFMD). All of these measures are adding to the workload of compliance officers at asset management firms.
Nobody believes that regulators are successfully digesting this data, and so getting a better handle on what is going on in the capital markets of the world. They more interesting question is whether they are able to do anything at all with the data or whether they are so swamped in information that they are unable to function except at the most basic level. Neither outcome is welcome to the asset management industry. Should regulators start to act on a partial view of the data contained in the reports, they could start to make ill-informed decisions. A further clamp-down on the so-called “shadow banking” industry, for example, would hurt asset managers which go short or use leverage. On the other hand, if regulators are paralysed by the sheer volume of the data they possess, they will continue to issue ill-considered directives while imposing massive costs on the asset management industry for no good purpose whatsoever.
A paradox is already apparent. Regulators that welcomed the increase in regulatory reporting as a job protection and creation scheme may find it has the reverse effect. As detractors of the SEC routinely point out, the agency was given specific, well-argued information about the massive fraud being perpetuated by Bernard Madoff, yet it failed to act even on something as well-understood as that. The abundance of data now being processed by the exposes them to the risk of being blamed for any accident that happens, on grounds they have more than enough data to spot risks, frauds and blow-ups well ahead of them actually occurring. “There is a risk regulatory bodies could be overwhelmed given the sheer magnitude of reports and data they are receiving,” says Grant Lee, director at PricewaterhouseCoopers (PwC) in London. “However, the SEC has had reporting functionality up from day one, and they have systems in place to accommodate the filing of Form PF. They are certainly not receiving and collecting this data manually.”
Collecting data is not the same thing as analysing it for decision-making purposes. The SEC has spent generously to enlarge its capacity to do both. In a study published this year, Kinetic Partners noted the regulatory agency had increased its expenditure by 62 per cent and its headcount by 22 per cent since 2006. Unfortunately, Congress slashed its technology budget in January 2014 to the tune of $50 million. This is what may be has increased the number of enforcement visits and the scale of the fines levied by the SEC. The same Kinetic Partners study found the average size of penalties issued by the SEC had increased by 36 per cent between 2008 and 2013. It now stands at $4.99 billion. This has enabled the SEC to implement substantial investment in internal infrastructure, staff and resources. One chief operating officer (COO) at a New York-based hedge fund acknowledges that the calibre and competence of the SEC staff he meets has improved in recent years.
As to their ability to make sense of the data they have commissioned, Form PF provides a useful test case. Form PF submissions to the SEC began in earnest in June 2012 for managers running in excess of $5 billion, while Form CPO-PQR filings with the Commodity Futures Trading Commission (CFTC) commenced in December 2013 for commodity pool operators (CPOs) and commodity trading advisers (CTAs). The first task of the SEC and CFTC is to work out whether the data supplied by managers in Forms PF and CPO-PQR is consistent and accurate. They are questioning firms where errors or misrepresentations appear. The SEC told Congress in its annual report on Form PF in 2013 that it would use the data obtained to bolster its approach towards private fund adviser examinations, investigations and investor protection. This was re-confirmed in the latest report on Form PF, which was submitted to Congress in August 2014.
The data from both forms was also upplied to the Financial Stability Oversight Council (FSOC), the body mandated under the Dodd-Frank Act to monitor systemic risk in the capital markets of the United States. The FSOC is currently in the process of assessing which non-bank financial institutions qualify as systemically important financial institutions (SIFIs) and Form PF data is being used to assist them in that endeavour. Should certain asset managers be designated as SIFIs, they could be subject to bank-style regulations. However, the FSOC reportedly told its staff to re-focus their efforts on the type of products asset managers are selling to investors, and the activities they are undertaking.
The information gleaned from Form PF is being shared across departments within the SEC as well as with other federal agencies. The Division of Economic and Risk Analysis (DERA) at the SEC plans to use the data to identify aberrant investment performance and trends and to conduct peer group analyses. The Risk and Examinations Office of the Division of Investment Management, meanwhile, will liaise with DERA on how best to monitor the risk-taking activities of fund managers. It will provide internal reports on its findings, which will be used to drive policy. The Office of Compliance Inspections and Examinations (OCIE) will also use Form PF data to assist them in pre-examination research and in identifying trends and emerging risks. The SEC report to Congress report added that Form PF will be used to periodically update thematic exams. Finally, Form PF will be shared with the Asset Management Unit of the Enforcement Division of the SEC as part of their investigation and enforcement activities.
The SEC has also promised to provide “certain aggregated, non-proprietary” data submitted in Form PF by larger hedge fund managers (defined as entities managing in excess of $1.5 billion in Regulatory Assets under Management (RAuM)) to foreign regulatory agencies, including the International Organisation of Securities Commissions (IOSCO). IOSCO is working with the Financial Stability Board (FSB) to determine the criteria by which to judge whether a fund manager is a SIFI. In January 2014, the FSB and IOSCO published a consultation paper which recommended “materiality thresholds” to identify asset managers as SIFIs. The two agencies set a threshold of $100 billion in assets and an alternative threshold of between $400 billion and $600 billion in gross notional exposure for hedge funds.
While the SEC has been transparent about its intentions, there is less clarity around what the CFTC will do with the data it obtains from Form CPO-PQR. Obviously, the intention is that it will be used as a tool for risk-based examinations and investigations, and to help the CFTC identify build-ups of risk. There is also speculation that a data warehouse could be created by the CFTC to house all of the information contained in Form CPO-PQR submissions. This was all but confirmed at a CFTC Technology Advisory Committee meeting, at which delegates indicated that raw data from Form CPO-PQR would be uploaded to the CFTC servers by the NFA. This data will be formatted for storage in a database operated by the CFTC Office of Data and Technology. How soon this will happen, and how useful the service will be, is unknowable. “Both the SEC and CFTC have a huge amount of work to do, and both are resource-constrained agencies,” says Chris Riccardi, a partner at Seward & Kissel in New York. “Whether they are effective in achieving their stated objectives remains to be seen.”
What European regulators are doing with data obtained via Annex IV and from derivatives reported to trade repositories is less clear-cut. First, Annex IV submissions have yet to begin in earnest, although the European Securities and Markets Authority (ESMA) intends to use the data to assess the scale of the systemic risks generated by the alternative investment management industry. However, the AIFMD is less about systemic risk than investor protection, and national regulators will comb through Annex IV reports for discrepancies between the data reported and the strategies outlined to prospective or existing investors in offering memorandums and prospectuses. Inconsistencies will be treated as evidence that funds were mis-sold. Indications from the Financial Conduct Authority (FCA), the United Kingdom regulator, as well as ESMA indicate Annex IV submissions will face similar regulatory scrutiny to that of Form PF. It is likely regulators in Europe will compare data provided to them with data supplied to the SEC and the CFTC in the United States, again in search of inconsistencies. The data supplied through Annex IV will also be used to inform policy, and in particular the next iterations of the AIFMD. ESMA is conducting a wholesale review of the Directive in 2015.
The botched introduction of derivative reporting under EMIR, in which the European Commission insisted on adding ETDs ton the reporting obligation and ESMA did not clarify technical standards until the night before reporting became mandatory on 12 February 2014, is not an encouraging portent of what the regulators will actually do with the data. More than six months after reporting became mandatory, pairing trades reported by counterparties to different repositories was still proving impossible, and data fields were not being complete consistently. That ESMA asked the European Commission not to include ETDs was indicative of the state of preparedness of regulators as well as market participants. An executive at the Depository Trust & Clearing Corporation (DTCC), one of the six ESMA-licensed trade repositories - the others are Regis-TR, UnaVista, CME Trade Repository, ICE Trade Vault Europe and KDPW - told the International Derivatives Expo (IDX) Conference in London in June that just 30 per cent of inter-repository OTC derivatives and 3 per cent of exchange traded derivative transactions were at the time being paired successfully.
Pairing is only the first stage to matching the two sides of a trade successfully. Unpaired trades cannot be matched. The keys to successful pairing and matching are Legal Entity Identifiers (LEIS) and Unique Trade Identifiers (UTIs). While LEIs were relatively easy to obtain from a number of licensed authorities known as pre-Local Operating Units (pre-LOUs), ESMA sanctioned four different methodologies for generating a UTI, did not publish them until 11 February 2014, and failed to specify which of trading venues or trade confirmation platforms or central counter-party clearing houses (CCPs) or which of the counterparties was responsible for generating them. The result was chaos, with counterparties making up their own UTIs just to populate the field. Trade repositories found themselves locked in discussions with ESMA to work out which data fields should be used to match trades, but failed to persuade the regulator to lay down the law on who should generate a UTI. Fund managers remain bewildered. Until reporting is stabilised, and data submitted by different counterparties becomes consistent, the data being collected by European trade repositories cannot be used at all. Unfortunately, even when it is useable, it will almost certainly be useless for practical purposes anyway. But utility is not necessarily the point of regulatory reporting.
For a full description of these terms see the COO Connect Guide to Derivative Reporting in Europe