In 2008 the U.S. economy faced a series of events that revealed weaknesses in our financial system and forced the government to impose regulations in an attempt to restore market stability and investor confidence. There is debate if the stock market crash was systemic from previous issues such as the collapse of sub prime mortgages and credit markets or if it was due to relaxing the up-tick rule and allowing investors to engage in naked short sales while the market was already on its way down. Regardless, there are more regulations to come and one of the government’s targets is the high profile, loosely regulated hedge fund industry.

In 2008 the United States Securities and Exchange Commission (“SEC”) and the United Kingdom’s Financial Services Authority (“FSA”) took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence. This action temporarily halted companies operations and prevented portfolio managers and traders from effectively making investment decisions and executing trades.

On April 8, 2009, the U.S. securities regulators met to consider restrictions on short selling and SEC Chairman Mary Shapiro said the agency is starting a “thoughtful, deliberative process” on how to address short selling as the strategy undermines investor confidence. The SEC and FSA are consulting on an ongoing basis with regard to short selling matters and will continue to carry out regulatory actions when markets are not functioning well. Investment firms both the sell-side and the buy-side need the ability to obtain and translate regulatory rules and implement them on a timely and accurate basis in order to stay compliant and ensure that investment managers and traders are able to make investment decisions without missing the markets.

The Managed Funds Association (“MFA”), The Voice of the Global Alternative Investment Industry, is lobbying to allow the practice of short selling as they believe it is integral to improving the efficiency of markets by enhancing market quality through narrower spreads, deeper liquidity, less volatility and greater price discovery. The MFA believes that short selling should be limited to covered sales and naked short selling should be prohibited. The MFA believes this practice should be implemented globally and they are looking to the government to impose procedures and controls on the broker/dealers that facilitate trades in the various listed and over-the-counter markets. However, broker/dealers already have procedures in place to ensure that a short sale is covered. The broker/dealers don’t have control over a fund’s net position when the fund utilizes more than one prime broker to settle trades and custody their positions.

It is our belief that as the government imposes regulations on hedge funds to manage risk and financial reporting they will also force the hedge funds to take responsibility of accurate order and trade reporting as this will reduce the chance of intentional or unintentional market manipulation.

Regardless of an investment firm’s Assets Under Management (“AUM”) and physical head count all were subject to the banned short sale security rule imposed in 2008. Most investment firms leverage applications provided by third-party administrators. These systems are designed mainly for post-trade entry, operations and accounting functions and do not provide compliance functions. These systems usually do not provide portfolio managers and traders with real-time position management and the Security Master File (“SMF”) will not capture securities listed on the banned short sale list. In addition, larger investment firms seeking competitive lending rates and those who run funds for “Managed Accounts” have relationships with more than one prime broker. This complicates the firm’s ability to determine their net position and determine if they can sell a security on the banned short sale list. In fact, if a firm cannot determine their net position then they can’t determine if a sale order should be marked as long or short when the order is given to the broker/dealer for execution.

The ability to capture information from regulatory agencies, translate it and provide it to investment managers and traders requires coordination and technology efforts. The best solution will proactively inform the portfolio managers and traders of current rules so they can effectively make investment and trading decisions without slowing them down.

FinServ Consulting has experience working with firms to ensure regulatory requirements are met both by the front-office for investment management and trading purposes and by the back-office for reporting requirements. We have experience in obtaining pertinent regulatory information and applying it to an investment firm’s trading, operations and accounting areas to ensure compliance with the rules and regulations imposed and that investment decisions and trading operations are not interrupted.

FinServ begins by analyzing a firm’s current technology infrastructure to determine what can be leveraged. The SMF is the backbone of all securities trading and data integrity is crucial. A proactive solution would be to incorporate regulatory information into the SMF or provide a custom application that does and have it interface with the SMF.

Example Solution Provided to a Top Tier Hedge Fund:
FinServ created a custom application for a client to manage real-time security positions and regulatory requirements. The application was provided to the back-office for reporting purposes and the firm’s front-office execution management system interfaced with it to determine if a sale order was allowable. If a security was included on the banned short sale security list the trader is prompted with a warning message and the order is restricted from being forwarded to the executing broker. If a security was not included on the banned short sale security list and a portion of the sale order was greater than the fund net position, the trader was prompted with a warning message stating the number of shares that were being sold short and it required the trader to enter the broker name that the trader obtained the stock borrow from. We also leveraged this custom application to provide regulatory information on the firm’s intranet site.

It is inevitable that the government will impose regulations on short selling and their primary target is the hedge fund industry. Funds that take proactive steps in implementing controls in risk management, financial reporting and trading will gain more control over their business and make smarter investing decisions. Not only will these funds comply with government regulations, but more importantly they earn confidence from existing and potential investors.

FinServ Consulting is an independent experienced provider of business consulting, systems development and integration services to alternative asset management firms and their service providers, providing expert, tailored guidance in the design and implementation of business processes aligned with technology and systems.