What Hedge Funds Can Expect From The New Regulations

Hedge funds are bracing for more regulation from the Obama Administration, which is seeking more dislosure on relationships with counterparties to prevent systemic risk.But rather than sit on the sidelines and wait for the new rules, one industry consultant urges alternative asset managers to prepare for more reporting requirements."The more prepared for the regulation, the more cost effective it can be," said Howard Weinstein, managing partner at FinServ Consulting LLC, a systems integrator in New Jersey, whose firm focuses on hedge funds and private equity firms. I spoke with Weinstein, who released a white paper, "Preparing for Alternative Asset Management Regulation," last week.

All of Weinstein's clients, including some prominent funds whose names he can't divulge, think that regulation is coming and are trying to figure out what the regulations will be. In fact, the white paper quotes several hedge fund executives, including the CFO of Tudor Investments and the COO of Silver Point Capital.

Since nothing has been definitively announced yet, executives are focused on reading between the lines of what Treasury Secretary Tim Geithner and SEC Chairman Mary Schapiro have been saying, said Weinstein. Hedge funds are expecting the government to create a systemic regulator and to require more regular reporting on counterparties and positions, says Weinstein.

"What they're saying is, because of AIG and because of the risks to the whole system, they're really looking for a systemic regulator. They're going to be looking at how leveraged they are and how big they are," said Weinstein. They don't want credit default swaps to bring down the whole industry," said Weinstein.

But are the hedge funds prepared to provide more information to the government regulators such as their positions? That would probably make hedge funds cringe. "That's kind of their secret sauce," said Weinstein, who related, what the hedge funds believe they're going to have to provide is a certain amount of standard reporting and that's probably going to be on counterparty exposures.

Part of the problem that surfaced last fall and pointed to weaknesses in risk management is that it took some hedge funds several days to figure out they had exposure to Lehman Brothers last September and then their funds were frozen in the bankruptcy. Therefore, the current discussion on potential regulation is focusing on asking the hedge funds to identify their counterparties and what their exposure is to them and what deals they are in, according to Weinstein, all of which is sensitive information.

On top of this aspect, hedge funds are expected to be under greater scrutiny as a result of the Madoff fraud. Even though Bernie Madoff's firm wasn't a hedge fund and was technically a registered investment adviser, his positions were fictitious and he never made any trades. And hedge funds that invested in his strategies never owned what they thought they owned and failed to validate what he owned.

In addition, investors are gaining more clout and demanding more information. "In the old world, where hedge funds were in a superior position and didn't have to give out much information, but now the tables have been turned," said Weinstein. The money has flowed out of hedge funds and now investors will demand more information before they put it back in, said Weinstein.

So the question is from a technology standpoint how prepared are the hedge funds to provide this information to regulators? While hedge funds have made significant investments in front-office technology related to their trading strategies, the new regulations are going to require them to invest in middle and back-office applications. Weinstein believes the IT groups in the middle and back office are less sophisticated. Many firms are still using Quick Books and Peachtree as their common general ledgers and ERP systems, he observed.

"The challenge is going to be that we're in a down economy and the majority of hedge fund were laying off staff and cutting their budgets and now with regulation they're going to be forced to invest," said Weinstein. On the other hand, this could be a huge opportunity for hedge funds because they will have the impetus from the impending regulation to use as justification for making the investment in middle and back-office systems.

Given that regulations are on the horizon, are hedge funds starting on technology projects or are they waiting? Ironically, a lot of the projects that were underway last year and headed in this direction, were actually shut down because of budget cuts. 'There are a handful of clients that had the foresight to continue with these projects, but the majority of funds have pulled back. They've had to limit their projects to the top two or three that they can't do with out," said Weinstein. Most organizations are waiting to understand what the regulation will be before they attempt to get management buy-in, he said.

But Weinstein contends that waiting for the regulation to come out could be a disadvantage, comparing this to the industry's response to the Sarbannes-Oxley Act of 2002. The consultant, who was previously head of SOX compliance for global banks at Bearing Point, warns that a lot of companies back then, did the bare minimum or they waited until the complex regulation was more understood. He knows of firms that had to hire an army of 100 auditors to go through the financial controls with Sarbannes Oxley Section 404 and meet the date. They ended up spending two-or three-times what they could have spent, he claimed. "Had they started six months earlier they would have had some sort of system in place," said Weinstein. "The main point is ... put it in your budget now. If you wait until the regulation comes out, you're going to be scrambling and manually doing what you can do than if you set up the infrastructure."

Stay Tuned for Part II of my interview with Weinstein.Hedge funds are expecting the government to create a systemic regulator and to require more regular reporting on counterparties and positions,according to consultant/systems integrator Howard Weinstein. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio