July 26, 2011

Back during the Clinton administration, Commodity Futures Trading Commission (CFTC) chairperson Brooksley Born tried to regulate derivatives that were traded over the counter, just as the agency had regulated exchange-traded derivatives. She failed.

Over the next decade and a half, hedge funds and prop trading desks grew by leaps and bounds--in part, by trading such unregulated derivatives. Now buy-side trading desks aren't just facing regulation driven by a crusading CFTC chairperson; rather, they are facing regulation-- the Dodd-Frank Wall Street Reform and Consumer Protection Act--born of Congress' desire to correct the problems that led to the recent financial crisis.

"It's legislation rather than just regulation," says Matt Samelson, analyst and principal at Woodbine Associates, of Dodd-Frank. "And it's the biggest since the 1970s, if not the 1930s."

Here are 10 things every buy-side trader should know about the changing financial regulation:

1) Don't Rely on the $150 Million Threshold

Want to avoid regulation entirely? You can keep your fund below $150 million and stop reading now. But even if you can still earn the traditional two and 20 fee structure (2% of the assets under management and 20% of returns) and generate 10% average portfolio growth, that means you're capping your fund's potential revenue at $6 million. Not so attractive anymore, is it? Plan for a bigger future.

"There are best practices that one should follow, regardless of whether the regulator is looking," says Samelson about firms approaching the new $150 million threshold for regulation. "Be sure to know what is expected. Have the right staff, rules and controls in place to meet any particular inquiry. Everyone says that it's going to cost a lot. Well, it's the cost of doing business."

Adds Sang Lee, founder of Aite Group, "Hedge funds may not be familiar with or used to keeping certain records. For folks like that, it'll be a rude awakening." So read on.

2) Derivatives Trades Will Have to Clear

If you trade in derivatives, especially swaps, your world is about to get a lot more like trading in traditional equity markets. "Most standardized derivatives transactions are going to be cleared," says Sean Owens, director of fixed income research at Woodbine Associates. "There is a new operational and legal requirement for folks in the market."

Aite's Lee notes, "The biggest issue for trading desks is how the over-the-counter markets evolve."

As those changes evolve, buy-side firms have to determine which central counterparties (CCPs) are available in the product spaces where they trade, and they need to determine which brokers will clear their OTC trades, says Woodbine's Owens.

"When all derivatives trades were handled bilaterally, it was easier," says Tabb Group senior analyst Kevin McPartland. With the move to using clearinghouses, buy-side traders will face different collateral requirements at various clearinghouses when they post margin.

3) Be Prepared

Because regulators are still working out many of the details for implementing Dodd-Frank, buy-side firms need to be as prepared as possible. Now is the time to learn as much as possible and begin preparation for implementing changes. Prime brokers can be one source of information to tap. So can your legal counsel.

While specifics may still be forthcoming, the general trend is clear. "They'll need to provide more frequent data to their vendors to create reports," says Bill Beaulieu, managing director at Beacon Consulting Group, of buy-side firms. "Tracking, real-time booking--funds will need to find a platform if they aren't doing it today."

Confirmations by fax? Fuhgedaboudit.

"As [hedge funds] continue to see increased regulation in their space, it's difficult to keep up with manual processes," says Aite's Lee. The move to greater automation, however, may raise questions about which products a buy-side firm should trade, he points out. "They might not have done enough trading in the past to warrant a technology infrastructure."

Infrastructure means more than just technology. You need to identify the right human resources, too. To figure out what kinds of skill sets you'll need, start by determining what you will be validating on a regular basis, says Beacon's Beaulieu -- and how frequently you need to do that validation.

Again, this doesn't mean you have to hire bodies for each role. Your administrators may be able to provide legal services, for instance. But you need to think it through carefully.

4) Regs Shouldn't Dent Equity Liquidity/Dark Pools

Keep in mind that Congress' intent is to reduce the risks to the overall financial system, especially at banks. "Dodd-Frank and other regulations look to disengage irresponsible risk-taking from institutions that people are entrusting funds with," says Woodbine's Samelson. The reduced role of bank prop trading desks in providing equity volume, he notes, will be picked up quickly by hedge funds--with one possible exception: Liquidity for small cap stocks may decline.

However, increased compliance checks--such as pre-trade verification of risk policies--may slow down the ability of high-frequency traders to capture arbitrage movement. "If you're a value manager, your return is more predicated on more fundamental analysis," says Samelson. "You've got a lot more latitude."

Regulators' main concern with dark pools is that too much liquidity goes off-exchange, distorting price discovery and price formation. Some estimates place dark pool/crossing network volume as high as 30% of all equity volume, but Samelson says it is likely closer to 10%. But broadly, regulators seem to see regulation as unworkable for many activities surrounding dark pools.

However, one practice that may draw Congress' and regulators' ire, says Aite's Lee, is some dark pools' use of indications of interest that look and smell like a quote. "There will be a movement to eliminate that activity," he contends.

5) Build Out Risk Management...

"Every firm should have some sort of risk management policy--whether on paper or electronic," stresses Lee.

Although this may have been done perfunctorily in the past, risk management needs to become a regular part of the workflow. Now, you're going to have to monitor positions against your risk policy on a much more frequent basis--daily on positions the fund holds, notes Woodbine's Owens, and even more frequently for any collateral that you've posted.

Have questions about how to do it right? Find someone in your firm, or at a peer firm, who comes from an equity background. The practices for managing risk in equity markets stand as a good model to follow. Also, ask your vendors, whether administrators or legal counsel, for help building out the function for your firm.