Decomposing FoHF returns
Where and when funds of hedge funds add and lose value
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08/09/2010
Comment: Julian Korek
Despite its impending abolition, it’s business as usual at the Financial Services Authority (FSA), as it continues to focus on intense supervision and adopts a more intrusive, enforcement-driven approach. High on the FSA’s agenda is transaction reporting, which the UK regulator believes is key in winning the battle against market abuse.
Although the UK has led the way with transaction reporting, the agenda and direction is now being set at a European level with the roll-out of reporting on over-the-counter (OTC) derivatives and instruments admitted to trading only on multilateral trading facilities (MTFs), expected shortly.
In addition, the Committee of European Securities Regulators (CESR), as part of its Markets in Financial Instruments Directive (MiFID) review, has released a number of consultation papers considering requirements such as a new trading capacity ‘riskless principal’,
client/counterparty identifiers, extension of the reporting regime to non-authorised firms and establishment of third-party reporting mechanisms in the form of trade repositories.
While in general, the reporting requirements across the spectrum of firms have become more onerous, there is a ray of light for portfolio fund managers (PFMs) relying upon the FSA’s ‘portfolio fund manager exemption’. The FSA announced that they can rely upon another party, without the need for extensive due diligence, to report transactions. PFMs need only be satisfied that the broker is a MiFID investment firm with obligations to report under MiFID.
However, firms should be careful not to place too much reliance on the exemption without fully considering the exceptions and nuances of this ruling.
The most common mistake firms are making is thinking that they can rely upon non-MiFID investment firms, such as US investment banks, to report on their behalf. This becomes problematic where a branch passes an order to a non-EEA (European Economic Area)-based entity to execute and the PFM fails to distinguish between the entities. If there is any doubt, firms should report the transaction.
Non/mis-reporting swiftly highlights whether a firm has adequate systems and controls in place, thus warranting a visit or wider compliance review by the FSA. Furthermore, as competent authorities, such as the FSA, share transaction data via the central Transaction Reporting Exchange Mechanism (Trem) there is heightened sensitivity and importance of data integrity, as poor quality data will reflect badly on the local regulator.
Firms must be careful not to take their eye off the ball, as enforcement action for reporting failures is increasing in frequency and severity. In April, the FSA fined three firms a total of £4.2m ($6.45m) for failing to provide accurate and timely transaction reports, and more are rumoured to be on the way. Firms should ensure they have comprehensive systems and controls, and these processes are reviewed on a regular basis, to avoid transaction reporting breaches, a substantial fine and being publically named.
With the growth in popularity of debt instruments, including collateralised loan obligations, PFMs must be careful not to slip on these potential ‘banana skins’. While the loans themselves are not reportable, the use of bonds may result in reportable transactions if they are listed on a regulated stock exchange, such as the Irish Stock Exchange. Dual listings can also be problematic, not least because they can be difficult to identify. The solution is that any financial instrument admitted to trading on an EEA-regulated/prescribed market, regardless of any dual listing on a non-EEA market, is reportable, and where a non-EEA broker is used to execute the trade, the PFM must also report.
Due to the desire for greater oversight and control of transaction reporting, several fund management firms have made a conscious decision to self-report. This has the added benefit of allowing such firms to request data from the FSA website to conduct the necessary integrity reports and avoid being caught out by any of the exceptions to the PFM exemption. This is a trend I expect to continue as the penalties keep on rising
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