Hedge funds warned on trade fails and mismatches in white paper

Operational Risk
12 Nov, 2013

Hedge funds have been encouraged to automate their trading processes to mitigate the number of trade fails or mismatches during the settlement process, particularly once the EU’s Central Securities Depositary Regulation (CSDR) comes into effect on January 1, 2015, according to a white paper published by Cor Financial Salerio.

CSDR seeks to shorten and harmonise securities settlement cycles across the EU – and aims to reduce the number of trade fails, costs and operational risks inherent in cross-border transactions, and will force market participants to settle their trades no later than two days after the trade was executed in what is known as T+2. Failure to settle within the T+2 cycle will incur financial penalties.

The white paper argued CSDR would increase the number of failed trades for hedge funds which have not accurately confirmed trades before sending information to brokers. Under the existing contractual settlement agreements between prime brokers and hedge funds, the prime broker will absorb the costs for any trade fails or mismatches, and assume all the risk until the settlement is finalised. In a T+2 environment, the costs for prime brokers to absorb trade fails or mismatches will jump exponentially.

This could lead to prime brokers assessing whether or not to continue working with managers which have a high number of trade fails, or at least tightening their margin financing or increasing fees. The managers likely to be impacted the most by this are those which rely on manual as opposed to automated trading processes.

“I doubt prime brokers would actively terminate relationships with existing hedge funds if they had a high number of trade fails or settlement fails but it could lead to restrictions on margin financing or higher fees. A lot of the tier one prime brokers insist hedge funds provide data in a high quality format to prevent the risk of trade fails, although this is not the case with some of the tier two prime brokers,” said Paul Bowen, head of client servicing at Salerio.

An increasing number of institutional investors are also advising managers automate their trading processes. “Institutional investors when conducting operational due diligence want their prospective managers to have highly efficient operational infrastructure. In other words, they would prefer these managers to rely on automated systems and processes rather than having a manual set-up,” continued Bowen.

Some managers, particularly smaller hedge funds, point out automation could be prohibitively expensive at a time when overheads are rapidly increasing. “While there are costs associated initially with automation, the overall expenditure is not that significant and having efficient trading processes in place can actually help managers keep overheads manageable. However, a lot of managers are presently focused on achieving compliance with regulations such as AIFMD so not all of them are prioritising automation at present,” he said.

There are some schools of thought, the paper continued, which argued electronic matching of trades ought to be made compulsory. “The trading cycle and flow of information within it is clearly business critical to any investment management firm. Some of the inherent operational risks of that cycle – including operational risks to hedge funds’ interdependent partners – are all but obviated by this simple step,” read the paper.

Whether or not such regulation would be viable is open to debate. “In theory, yes it could happen, but it would be very difficult to enforce. For example, how would regulators define electronic automation or matching? It would be a challenge to impose such a requirement,” said Bowen.

CSDRT+2. Cor Financial SalerioAIFMD