Compliance issues for hedge funds is an age old problem to keep on top of, but could new technology offer fresh solutions to long-standing issues?
According to research from Ocorian and Newgate Compliance, alternative fund managers are losing investment mandates or clients due to compliance problems.
The research showed that 81% of alternative fund managers admit compliance issues have meant losing investment mandates or clients over the past three years, while 90% have stated that conflicts between fund management teams and compliance risk teams have occurred within their organization in recent years.
This underlines the importance of overcoming compliance issues in a transparent and conducive manner for institutional investors of all scales. With this in mind, let’s take a deeper look at how emerging technology is paving the way to overcome the six major compliance issues facing hedge funds today:
Reporting
According to a recent survey, hedge fund CFOs expect investors to demand greater volumes and frequency in financial reporting over the next five years ranging from trading and performance data to risk parameters and ESG.
In total, 33% of survey respondents have identified demands for daily reporting on strategy-level performance, while 9% have reported seeing demands for live reporting.
With SEC chair Gary Gensler calling for greater scrutiny over hedge funds in the wake of recent issues surrounding the US government bonds market, it’s clear that transparent reporting will form the foundation of compliance in the future.
Fortunately, this is where artificial intelligence can transform compliance for hedge funds. Uniting the data visualization capabilities of generative AI with machine learning means that live reporting can soon become a reality and a time-efficient, low-cost resource for investors and internal users alike.
For regulators demanding greater scrutiny, artificial intelligence can incorporate data transformation tools to provide accessible resources for end users to use integrated data for powerful insights.
Marketing
Marketing for hedge funds is impacted by many different regulations both regionally and internationally.
While the SEC’s Advertising Rule (Rule 206(4)-1 prohibits making false or misleading statements within marketing materials, FINRA Rule 2241 stipulates that the regulatory authority governs the use of research reports in hedge fund marketing, including requirements for disclosures and analyst certifications.
In the US, state regulations can be varied depending on jurisdiction, and international regulations like the EY Alternative Investment Fund Managers Directive (AIFMD) require hedge funds to register with local regulators and comply with disclosure and reporting requirements.
Another international regulatory requirement comes in the form of the UK Financial Conduct Authority (FCA) which claims that hedge fund marketing activities nationally must be governed by the body, with significant legal and reputational risks like fines, sanctions, and investor redemptions possible for those who break the rules.
Artificial intelligence is also improving the marketing landscape for hedge funds at scale, and generative AI programs like Copy.ai and DALL-E are both widely utilized for the creation of artwork, social media posts, and other rich marketing materials.
However, it’s machine learning (ML) that can help to make strides in monitoring marketing compliance at scale for hedge funds. For funds that have an international presence, ML is capable of actively monitoring regulatory requirements in regions of operation, alerting end-users whenever a perceived breach of compliance could occur while preparing new marketing campaigns in international markets in particular.
Proportionate Segregation
Hedge funds will also need to collaborate with regulators to establish how to structure internally to meet expectations for risk management, valuation, and compliance functions on a proportionate basis.
For hedge funds where key roles are shared between single members of management can cause particular challenges in this regard. Should a CIO also be a majority owner of the fund, concerns could arise over alignment to wider standards, governance, and culture within firms.
The continued emergence of blockchain technology could be pivotal in this area of compliance. Managers plan to increase spending on blockchain by 21% over the next two years, and the adoption of digital ledgers can work wonders for transparency and accountability within firms.
Blockchain tools can help boost transparency within organizational structures and introduce voting rights on key company decisions among stakeholders. This can help to introduce more democratized processes for hedge funds without having to shake up long-standing hierarchies.
Overreliance on Automation
While we’ve already covered how hedge funds can use AI to deliver compliance at scale, the technology itself is set to be subject to increasing scrutiny over the coming years as it continues to develop.
This calls for the adoption of a more collaborative approach between institutional investors and emerging technology. While automation can help to perpetually monitor markets, internationally-focused prime brokers can help to deliver around-the-clock monitoring of US securities from distributed locations to ensure that that all-important human touch is on hand to ensure sustainable levels of compliance even as technology grows.
Conflicts of Interest
Greater scrutiny will also be placed on how hedge fund managers overcome possible conflicts of interest between themselves and their clients, using technology to help deliver a level of service that’s in keeping with the firm’s culture.
Conflicts of interest can emerge from many places and the introduction of MiFID II restrictions for firms to receive only ‘minor non-monetary benefits’ from third parties linked to their services indicates that concerns over the best interests of clients are key.
Using the algorithmic technology packed into Expert Advisors (EAs) can be a significant step for hedge funds to innovate beyond the biases that could arise from conflicts of interest among managers. While it’s important to maintain a human element in curating and acting on investment opportunities, EAs programmed to align with a hedge fund’s core strategies and work alongside managers can help foster a more compliant environment.
Market Abuse Control
With regulatory bodies like the FCA seeking new ways to enforce action against firms that harbor activity that doesn’t comply with established compliance, it’s essential for firms to do more internally to overcome scrutiny.
Machine learning will also be an asset in this particular area. Rather than monitor externally for regulatory changes, the technology can take an internal approach to monitor processes to ensure that no regulatory bodies can determine that market abuse is taking place.
Seeking Sustainability in Compliance
The boom in emerging technology surrounding institutional investing is both a blessing and a curse for hedge funds. While new tools like AI and ML are opening the door to new levels of compliance monitoring, they’re also adding to the level of scrutiny endured in the face of regulators.
However, the ability to safeguard against possible conflicts of interest, irresponsible marketing, reporting challenges, and the many other regulatory pitfalls hedge funds must overcome can be bolstered by the emergence of powerful new tools.
This can pave the way for a more sustainable approach to compliance, with more time and effort saved on monitoring and more resources invested in innovations and capitalizing on new opportunities.
The post How Hedge Funds Can Navigate 6 Major Compliance Issues with Emerging Technology appeared first on Datafloq.
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