In recent years, money managers have put an increasing emphasis on strengthening their compliance departments. Several factors have contributed to this emphasis on compliance:
- increased difficulty of maintaining compliance in the face of the financial industry's growth with respect to globalization, assets, sophistication, and complexity;
- increased scrutiny, higher standards and tougher sanctions from regulators; and
- several high-profile buy and sell-side failures which resulted, at least in part, from inadequate controls and procedures.
There are often enormous costs associated with a failure to comply. Some compliance failures necessitate a reversal of a non-complying trade, causing the institution to risk losing money due to market movement. Some trades expose a client to an unacceptably high level of risk that prove costly to the client and, ultimately, to the adviser or broker in the loss of that client. The money manager may be compelled to pay large sums to correct compliance failures, either in the hope of avoiding litigation or as a result of litigation with private parties or with regulators.
To meet the heightened demands placed on compliance personnel, many money managers have turned to technology to bring increased accuracy and improve overall compliance. The solution-automated compliance systems-takes one of three forms: post-trade compliance, pre-trade compliance or stand-alone compliance.
The simplest and least effective system from a risk exposure standpoint is a post-trade system. These products test trades on either a daily or more infrequent basis. Although this system facilitates the compliance process, it does so only after trades have been executed. While uncovering a violation, this system will not prevent a violation from occurring. As a result, a post-trade system does not eliminate the risk exposure faced by an investment adviser or broker from a violation.
The second system that has developed in recent years is pre-trade compliance that tests each trade before the order is executed. Typically, these pre-trade compliance systems are integrated into and become part of a trade order management system or portfolio management system. An automated pre-trade compliance system typically requires a trader to check the proposed trade against the compliance system prior to executing a trade. The pre-trade compliance system then indicates whether, in view of any restrictions that have been programmed into the system, the security and transaction quantity are appropriate for the accounts in question. If they are appropriate, the trader may then execute the trade. If not, the system alerts the trader that the proposed trade violates an account restriction with respect to one or more of the accounts involved. The trader then has alternative options on how to proceed.
Automated pre-trade compliance systems provide a number of benefits to the securities industry. By integrating compliance with order management and portfolio management systems, much of the firm's compliance function is moved from a typical 'back-office' function to the front office. Compliance is now in the hands of the traders and the portfolio managers of the firm. With the pre-trade compliance systems, traders and portfolio managers are able to know before a trade is executed whether the trade would violate any restrictions for the particular account or accounts. By increasing the traders' awareness of restrictions applicable to different accounts, these systems also tend to promote a stronger culture of compliance within the firm. In addition to uncovering trades that may violate an investment restriction, automated pre-trade compliance systems improve trade allocation and order processing for all trades. This, in turn, reduces costs of processing orders, correcting errors, and reversing trades. Without increased overhead or staffing, these systems bring scalability to the functions of compliance personnel, allowing them to handle increases in trading volume coming from today's economy and market without corresponding increases in costs or staffing. Automated compliance systems provide other benefits, primarily in the area of audit trails and record keeping. The automated systems should also be able to provide lists of securities that would satisfy certain trading requirements -- thus giving traders assistance in the trade decision process. Finally, the systems should be able to create compliance reports that alert the compliance officer to accounts that have positions close to a violation level before actually causing a violation. The third system currently under development is a "stand-alone pre-trade compliance" system. This version of pre-trade compliance has the unique advantage of not being integrated with any one trading system. The stand-alone compliance system allows the client complex to check trade information generated by multiple trade order management systems. All of the complex's trades are then checked for compliance by a single stand-alone compliance monitoring system. Consequently, if a trade being proposed by the money market desk of a complex in conjunction with a trade generated by the equity-trading desk would violate a rule, the stand-alone compliance system would be able to stop the violation. More and more information technology managers of the major money management firms are looking to centralize their various processes -- they have multiple trading and portfolio accounting systems, each with its own database. Centralizing the data and compliance monitoring function simplifies these processes. Money managers often have internal company policies, which need to be adhered to across trading desks. Only a stand-alone compliance monitoring system, which is receiving trade information from all trading desks, has the ability to monitor these complex-wide policies. Currently there are systems that monitor compliance across multiple trading platforms -- but none pre-trade and therefore, none with the ability to avoid violations and all of the associated risks.
The future of the automated compliance industry lies in the unbundling of compliance from order management and portfolio management systems. The financial services arena, as a whole, is moving towards the acquisition of "best of breed" products. The stand-alone compliance product enables compliance personnel to achieve the same goal, thereby adding great value to the compliance industry.
About the author: Fredda Ackerman is President, CEO at CAI Technology Group, Inc., a software provider that builds out-of-the-box open solutions for trading floor technologies, whose flagship product, "ESTAC", is a stand-alone compliance product designed for global asset managers. Fredda can be reached at https://www.caitechnologygroup.com/.