Published on January 22, 2019 by Megha Wadhwa
“Good compliance is not just good business; it’s a requisite in today’s environment”
Prominence of Investment Compliance
Role of Investment Compliance as a function has largely evolved in the past decade. Earlier the main objective of this function in any asset management firm was to have protection against the operational risk and comply with the policies and regulations set up by SEC and other regulatory bodies. However, in today’s ever evolving financial market the objectives have diversified. Pressure on improved risk management, need for efficiency and transparency in the system, maintaining comprehensive audit reports and streamlining process with new regulatory requirements has increased.
A fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus. As these funds inherent a great deal of risk they need to be regulated and must comply with strict set of rules. The regulation of these funds is necessary to provide investors with confidence in investment structures and other benefits such as transparency, liquidity and safety.
Challenges faced in coding
Investment compliance provides a variety of services- ranging from analysis of Investment Management Agreement or prospectus of the fund for identification of restrictions and coding of these restrictions as well as regulatory guidelines on applications as rules. These rules are then run against the fund to flag potential violations post trade.
There are various comprehensive, high performance multi functionality applications available to the asset managers such as Fidessa’s Sentinel, State Street’s Charles River, Blackrock’s Aladdin and Bloomberg’s AIM etc. that help them manage their portfolios. These applications provide an end-to-end solution for analysis of trades, order management, pre trade checks, coding rules for compliance and post trade breach management. Investment compliance team helps asset managers’ mange these services.
Coding rules is the first step in Investment Compliance process. It refers to setting up of rules in the system per the IMA strategy. For e.g. the guidelines may prohibit investment in certain asset types or could be limiting the exposure to others for maintaining diversification in the portfolio. These restrictions are coded in the application and are run against the holding of the fund. Rules failing to meet fund’s objectives and strategies are then monitored under pre or post trade breach management process. Therefore, it is necessary for a compliance analyst to understand and code correct rules on the system. Listed below are the challenges that an analyst faces in coding such compliance rules.
Interpretation Issues :
Investment Management Agreement (IMA) is a legal arrangement that defines the terms of investment and management of the assets listed in the agreement among other things. These agreements are highly technical and differ in their structure so the identification and interpretation of the guidelines can be challenging. There is no standard template defined for these agreements and can be different for equity, fixed income and balanced funds with varying investment strategies across firms and regions.
IMA’s are drafted after detailed discussions and agreement between the client and an asset manager and defines the investment strategy that forms the basis for investment decision making and portfolio construction. Some of these IMAs may be highly restrictive with clear definition of do’s and don’ts while others may have open-ended statements where the portfolio management team has more freedom in decision making. Thus, even if the basic investment strategy of two mandates may be same, the portfolio construction will be dependent on the terms of the agreement and investment decision of the asset manager. This becomes challenging in defining and using standard rules across funds.
Most compliance managers prefer to have standard rule templates for a guideline rather than having multiple customized rules for the same across funds. This is difficult to maintain as there are various attributes of a rule that can vary based on IMA guidelines and PM’s requirements. To understand this further, let us consider a guideline restriction for maximum of 25% of total assets will be invested in the REITS. This is a simple rule to code which will flag whenever the investment in REITS will be greater than 25%. But before coding this rule a coder needs to check the IMA for possibility of multiple scenarios like- Is the guideline applicable to all holdings or only at the time of purchase? Is this a hard limit or just a soft warning rule for managers will do? Is there any specific definition mentioned in the guidelines for REITS or need to be coded using specific classifications like GICS or BICS or Lehman? Does the IMA specify the denominator to be used; that is investment in REITS will be limited to 25% of the total assets or only equity assets? Other than these there could be difference in the asset manager’s requirement as well. For example, if they would like the rule to be monitored at pre- trade, post- trade or at the end of the day. The level of hierarchy a security needs to be flagged at; like at security level or issuer level or parent issuer level? Or if they want a warning before any of the concentration rules flag for hard limits? These are only few examples of questions that a coder needs to ask himself before interpreting and coding any rule.
Data Setup Issues :
Data represents the informational characteristics of any investment product. Asset managers have access to large amounts of this data based on which they make the investment decision. There are multiple data providers which maintain and provide real-time financial market data and analytics for all types of products like Bloomberg, Thomson Reuters, FactSet, Morning Star etc. Let’s consider an example of Bonds. A bond will have multiple data points for its attributes like- type, issuer information, credit ratings etc. which will define its suitability for investment. Thus this becomes a major issue for coding team as not all the data might be available in a system for coding reference. For e.g., there is a lot of information about a bond that the PM team or trading desk will be able to acquire either through the issuer directly or prospectus of the deal but will not be available for referencing for coding as a data point in data providers database or if available might have an additional cost associated with it.
Also, the constantly evolving financial market requires data attributes and analytics to be updated regularly on real time basis. If any of the characteristics of the bond changes overtime due to corporate actions or is missing or is mapped incorrectly, the bond becomes a risky asset and may lead to a potential violation of an investment or a regulatory guideline. Thus, it becomes important for a rule’s coding to be able to identify and flag such securities.
Understanding of Investment products :
A product based on an underlying security or group of securities which has some risk associated with it but is purchased with the expectation of earning a favourable return is an investment product. Though these investment products look simple on paper; are pretty complex to understand when traded in the market. Thus it is very important for an analyst to possess knowledge of these products for coding as well as post trade management.
Also growth in the mutual and hedge funds has led to necessity in expansion of regulatory framework like Investments Act of 1940 and Undertakings for the Collective Investment of Transferable Securities (UCITS) for improved risk management of these portfolios. Demand for analysts with understanding of the financial products as well as the regulatory guideline has increased. But availability of such resources is scarce as today’s education system provides limited theoretical knowledge of investment products whereas the process requires one to have a thorough understanding of the working of product and specially the risk associated with each asset type.
Standardizing the process :
Coding of restrictions is highly dependent on the language of an IMA, its interpretation, requirements of asset manager, application used and the availability of data. There could be multiple combinations of the above factors and even a minor change in any of the above will lead to a need for another rule. Compliance team also has to be mindful while creating new rules as having duplicate rules in the compliance application may delay pushing future updates and may expose the portfolio to risk of having redundant rules for compliance checks. Additionally, an asset manager may use multiple in-house applications along with the main application to support ad-hoc functions. Thus like defining a template for a rule it is also difficult to standardize and document the coding process.
This issue can be somewhat resolved if one standardizes the guidelines across various strategies and regions. This can be done by creating and implementing a template for restrictions defined across same strategy funds. To achieve this, one not only needs to standardize the IMAs but also the definition of each asset class factoring the regional nuances. This can also be the first step towards automation of some of the elements of coding process.
Client list updates :
Sometimes clients prohibit investment in certain issuers/ securities which need to be adhered to at all times by the asset manager. This list may be provided by client on monthly or quarterly basis and needs to be maintained by the coding team. There are multiple challenges in coding and maintaining these lists.
Firstly, security/ issuer data linkage is a major risk in coding these lists. If an investment is prohibited at the security/ issuer level, there is a possibility of missing another security of the same parent company. If investment is prohibited at the parent issuer level, there is a possibility of several false violations. Also sometime the ultimate parent issuer of a company may roll up to sovereign issuers; like mostly Chinese organizations rolls up to Peoples Republic of China as ultimate parent issuer. This may lead to increase in noise of false violations and there is always a risk of missing a potential violation in that noise. Missing or erroneous data in security/ issuer data linkage also increases risk of missing true violations as a newly purchased security might not flag in the system at the time of purchase.
Another major risk is in governance around maintaining these lists. As these lists need to be frequently updated, a thorough and systematic comparison of the new and existing list needs to be done by the analyst before updating the same in the system. A single overlook can result in missing breach reporting and can have a huge impact on both client and asset manager.
How MA Knowledge Services can help
MA Knowledge Services investment compliance team helps asset managers in monitoring the funds for regulatory compliance obligations and assure that all investments and holdings of the fund are consistent with disclosures made to shareholders and the investment objectives stated in its prospectus. Our goal is to safe guard customer’s asset with a focus in delivering accurate, on-time services.
Five key features we offer to assist you in efficiently manage daily operations:
1) On-boarding new business- Our team will take point is analysing and interpreting the guidelines received for the new accounts. Any questions with respect to it will be raised to the client relationship team for clarification. Post which the rules would be coded in the application and tested for accuracy.
2) Audit the rule library- We understand the importance of compliance as a control function and the risks associated with it. Therefore, we also offer to review and update the existing rules with the changes in the investment/ regulatory guidelines or data setup.
3) Reduce volume of false violations- We also offer to analyse the daily violations received at pre/ post trade; identify the root cause and update the rules to avoid re-occurrence of such incidents. This will help in reducing the false exceptions and save time and efforts made by analyst to address them.
4) Standardization- We offer to define standard rule templates for common restrictions and creating rule libraries in accordance with the various strategies across different regions per best practices and availability of data.
5) Process enhancements- There are always opportunities to upgrade and improve workflow process. We offer to work with your internal teams to analyse any gaps in the process which could be eliminated / automated to reduce manual effort.
Our objective is to provide clients with scalable, cost effective solutions to eliminate risk and increase service quality. We also understand the evolutionary process of building strong compliance practices and need to change with time and therefore have been investing time and resources in learning NLP and Artificial Intelligence.
As a trusted business partner, it is our goal to make sure that our clients gets the best of service in third party investment compliance. We understand its significance and the responsibility we hold in delivering the service. That is why we created this white paper to share some of the common challenges faced by a compliance team and how our team can help in strong alert and breach management process. We hope you find it informative and helpful.
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About the Author
Megha Wadhwa has over 4 years of experience in investment compliance. In her current role she is working as an Associate with Acuity Knowledge Partners supporting Coding & Post Trade Monitoring functions and has previously worked with JP Morgan Chase. She holds MBA degree from IBS Hyderabad and B.Tech from Rajasthan Technical University.
04-Nov-2018 01:50:11 am
04-Nov-2018 03:48:35 am
Wow...Nice read... You have shared the really useful information.. I am sure that it will enhance the knowledge of all compliance professionals working in BFSI sector.
05-Nov-2018 07:10:54 am
09-Nov-2018 06:36:38 am
Very well written. Interesting insight into investment coding
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