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Hedge Fund Monthly
 
MiFID: Opportunity or Burden?

Russell Thornton, Fidessa

August 2007
 

As the MiFID deadline approaches, the clouds of confusion that once surrounded it have largely cleared. What has emerged is a directive whose primary focus is on best execution as a means of protecting the investor.

Many would therefore be forgiven for thinking that MiFID will be, at most, a minor ripple in a hedge fund’s operational pond but this would be to underestimate its impact on both the dealing processes within hedge funds, and the technology that is used to support them.

It may be tempting to discuss hedge funds as a homogenous group, but it’s a mistake to do so. The impact of MiFID is no exception. MiFID will clearly not affect all hedge funds equally, and the most important distinction to make is between those that manage their own money and those that make investments on behalf of other institutions or individuals. MiFID will be the cornerstone of the establishment of a post-scandal era, whose mantra is to protect the investor. It is therefore reasonable to assume that member-only hedge funds can, more or less, bypass its strictures.

However, that still leaves plenty of hedge funds that are likely to experience the same levels of scrutiny as their brethren in the more traditional mutual fund space.

The clear-cut distinctions that have historically existed between hedge funds and other investment firms are beginning to blur at the edges. Many of the strategies now being deployed by traders and portfolio managers at traditional investment houses had their origin in the hedge fund space, notably e-trading, DMA and the increased use of more exotic instruments.

Growing numbers of hedge funds also have a client base that is composed not only of high net worth individuals, comfortable with seeking out high-risk, high-return investment strategies, but also institutional investors who are less familiar with this world. Even the most risk-averse of institutions, including some previously very staid pension funds, are turning to the higher margins of hedge fund strategies to boost stagnant portfolios.

The changing client base has been accompanied by a more general move to regulate hedge fund activity. The SEC and even the US Congress have been making noises in this direction, and MiFID can be seen in the wider context of greater scrutiny and regulation of the sector as a whole.

The effects of MiFID are also more likely to be felt by hedge funds that count funds of hedge funds and manager of managers among their clients. These bodies face very particular demands from MiFID, and the due diligence processes they conduct are likely to be extremely stringent as they endeavour to pass these demands onto their chosen hedge fund.

In fact, MiFID requires organisations that have outsourced parts of their operations to third parties to maintain the same duty of care and internal controls as they would were they running it themselves. Combined with the renewed focus on best execution and transparency that is at the heart of the new regulations, this has serious practical implications for hedge funds whose order and execution management processes are likely to come under much closer scrutiny.

In effect, MiFID places increased emphasis on the need for broker-neutrality in the EMS. It is often argued that the affects of the new regulations will be felt on the sell-side far more than the buy-side. And while this may be true, it does not infer that sell-side derived software will be the most preferable option.

First of all, hedge funds are experiencing a degree of consolidation that is set to increase going forward. Larger funds in particular, frequently combine multiple strategies under one roof, which requires them to have technology that can execute with several brokers.

Then there is the issue of confidentiality. Naturally, this remains a constant area of concern for hedge funds who are wary of revealing their positions and strategies to anyone outside their four walls: sell-side provisioned software carries the nagging fear, however unfounded in reality, that precious layers of privacy will be breached.

More importantly, technology has historically been used by a number of sell-side institutions to lock clients into a broader product offering. These systems have been sold on the unique access they provide to algorithms and internal liquidity. But MiFID’s stipulations on quality control of outsourced services means that the days of basing decision-making on whose technology offers the broadest range of access, rather than choosing the right solutions from vendors whose underlying products and processes are the strongest, may be drawing to an end.

Indeed, there are lessons to be drawn from the buy-side where certain larger institutions are using their broker-neutral OEMS to rate broker performance and generate significant savings in the process.

Nonetheless, it is in the field of best execution, cost analysis and transparency that broker-neutral systems really come into their own. MiFID may be bringing transparency to the hedge fund sector, but it does not specify what best execution is, or how it is to be achieved. Instead it obliges firms to demonstrate that they have effective processes in place to meet the standards they set themselves. Systems that commit the user to the services of one broker therefore immediately limit the opportunities for both achieving and demonstrating best execution.

Hedge funds are faced with an almost overwhelming number of potential brokers, offering services that range from extremely high-touch to almost hands-off. In addition to broker liquidity and algorithms, a growing number of execution destinations and dark pools, hedge funds face an almost infinite combination of choices for each trade. In an arena where timely decisions can shave millions off costs, the right choice made at the right time can lead to significant, even dramatic benefits.

Broker-neutrality is therefore just the start. Hedge funds need solutions that offer all the sophisticated techniques seen on the sell-side that will enable them to take full advantage of all the options, trading at the right time, in the right way with the right partners.

Best execution also requires that systems have verifiable audit trails, time stamping capabilities and full reporting functionality – that must work across the entire business. One of the challenges that MiFID presents to many hedge funds is to try to break down the barriers between vertical business lines or strategy areas, around which legacy systems, or even entrenched manual processes, have been built.

However, none of this remains static. Brokers are currently engaged in what might be described as an ‘algo war’, attempting to get their latest offering out as quickly as possible, to as many people as possible. This means that a hedge fund’s EMS has to be able to incorporate these kinds of changes into the front end quickly, without extensive upgrading each time a new algorithm becomes available. The flexibility, scalability and adaptability of a solution is key – and will largely be dependent on its inherent architecture. It is unlikely to be a bolted on piece of functionality.

This points hedge funds in the direction of the ASP or hosted model. It retains the light touch that hedge funds need, and combines it with the flexibility necessary in the era of best execution. In addition, hedge funds who are well-known for their reluctance to spend large amounts of capital on new systems or IT staff to support them, can find cost-effective solutions, with just the right amount of functionality and appropriate layers of security in the ASP model.

The degree to which all of this impacts an individual hedge fund will also depend on the degree to which it already meets FSA standards, and how far EMS-style technology has already been adopted. For many less technical firms, MiFID may be the factor that drives them towards introducing more automated execution management.

Even for technologically advanced firms, MiFID provides an opportunity to add value to the organisation and deliver competitive advantage. The signs are there that best execution, like compliance systems at asset management firms before it, will be a key market differentiator. MiFID need not be simply another cost burden. Instead it can deliver huge advantages in the shape of streamlined processes, more cost effective trading, and an enhanced customer base.

 

 

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