Hedge fund outsourcing is not a new trend, as buy-side firms have long dispersed the responsibility of many functions to third-party service providers more adept and accomplished at said functions. Technology, for example, is an area where many firms choose to leverage outsourced providers to manage complete or partial infrastructures, support projects or supplement on-site IT staffs. The benefits to outsourcing are numerous, but the true measure of a successful service provider relationship comes when an investment firm’s level of risk in using that provider is low.
Risks are everywhere, particularly in today’s cyber-focused environment. But the risk a hedge fund undertakes when outsourcing a function of its business to a third-party is enormous. Not only is the firm relinquishing control to an outside company, it also takes on the added burden of managing that company, in addition to its own.
It’s one thing to put faith in your service providers to do their jobs effectively. It’s another to ignore your own firm’s responsibility to manage that third party as a means of protecting your own firm. Successfully managing risk associated with third-party service provider relationships is a full-time job, especially for financial services firms working with dozens of various parties. Here are a few tips to help your firm properly manage third-party service provider risk:
They say the more things change, the more they stay the same. Turns out it’s a pretty accurate assessment of the hedge fund industry then and now.
You see, back in 2011 we hosted a “State of the Hedge Fund Industry” event that yielded some interesting trends and perspectives, and we thought it might be fun to not only look back at those trends, but compare them to what we’re seeing in today’s industry – more than five years later.
Like I said: the more things change, the more they stay the same.
Hedge Fund Market Trends & Challenges
THEN (2011): It’s been an interesting year thus far for hedge funds and other alternative investment firms, as inflows have been high but performance low. In addition to performance challenges, hedge funds continue to deal with increased competition for investments, and thus asset-raising remains a hurdle for many funds – regardless of their size or strategy.
How much security protection is enough? That’s a tough question to answer and the catalyst behind our recently published whitepaper on selecting the right cybersecurity tier based on individual risk profiles (download it HERE). The paper outlines three common tiers including Tier 0 (the ‘must-have’ list) to Tier 2 (the ‘advanced’ list), however it only touches briefly on the human element of security.
The reality is that in today’s sophisticated cyber environment firms must go beyond physical or virtual firewalls firms and establish a ‘Human Firewall,’ because sometimes technology alone won’t stop some of the most damaging attacks. In many instances, employees are “holding the door open” to criminals or inadvertently “leaving the keys out.” At other times, disgruntled employees act with more malicious intent.
Building a ‘human firewall’ comes down to establishing a security-conscious workplace and culture where employees understand the risk landscape and know how to respond. So what goes into their ‘human firewall’? It has varying parts including policies, training, awareness and of course people(!).
Practical, User-Friendly Policies
Many firms create a 20+ page written information security plan that formalizes the definitions and policies that govern the creation, access, and deletion of confidential information and computing services. That can be everything from a definition of personally identifiable information (PII), a description of user access privileges and roles, or policies regarding data handling. What matters is that you’ve explicitly and unambiguously documented all aspects of your company’s at-risk assets and services.
While the plan should be comprehensive, firms should also avoid getting bogged down in “tech speak.” Employees need user-friendly policies that are straightforward to follow. For example, they want to know the implications of their actions (“If I read this on a mobile phone, am I creating a security vulnerability?” “What happens if I lose my mobile device?”).
2017 is already shaping up to be an interesting year. With a new presidential administration taking office and the hedge fund industry coming off the heels of a challenging year, there’s a lot to keep an eye on. We recently hosted a panel with law firm Morgan Lewis to discuss these and many other topics as part of our “2017 Outlook for Hedge Funds: Risk, Regulation and Technology” event.
Read on for some of our panel’s key takeaways.
2017 Regulatory Outlook
While little is known about how a Trump presidency will operate, there could be potential tax savings for managers depending on how the administration chooses to regulate Wall Street.
Firms should expect to see reforms with the Dodd-Frank Act and the Volcker Rule, which could add more competition into the marketplace if limits on bank investments are adjusted.
SEC Focus Areas
Top six areas of focus for the Securities & Exchange Commission will likely be: (1) expenses and fees, (2) trade allocation, (3) material non-public personal information, (4) valuation processes, (5) operating partners and due diligence, and (6) security, privacy, insider trading and business continuity.
Cybersecurity is not necessarily part of every SEC examination, however, the bar will continue to be raised in terms of preparations firms will need to employ.
In 2016, the SEC provided additional guidance on business continuity and transition plan requirements, highlighting the need for hedge fund and financial firms to maintain their fiduciary responsibility to their clients and investors.
Categorized under: Security Cloud Computing Disaster Recovery Hedge Fund Due Diligence Hedge Fund Operations Hedge Fund Regulation Outsourcing Infrastructure Business Continuity Planning Trends We're Seeing
As we prepare our turkeys for Thanksgiving and retail stores of all shapes and sizes prepare their inventory for Black Friday and Cyber Monday sales, cyber criminals are preparing their attacks. Your inboxes are likely already flooded with the newest and most popular deals for this holiday season, but while we all prepare to shop til we drop, it is important to practice safe computing practices while you are out-of-office and in the stores.
Here are some popular scams to watch out for this holiday shopping season:
Phishing emails pose one of the biggest threats to shoppers during the holiday season. Cyber criminals may be spoofing retailer emails with blowout deals on the best toys for your family, and one click on a spoofed email could result in malware or a virus installed on your computer. Another email spoof could appear to be from one of your frequently visited retail sites and ask you to enter personal information to either confirm a purchase or verify payment. To avoid handing your sensitive information over to hackers, be sure to check the sender and any links in emails before opening or taking action on any suspicious emails.
Email isn't the only way hackers can spread the season's "hottest deals". Another new scam being used to gather banking and payment information is phishing texts. Your phone will receive a fake text message asking to verify a payment due to irregular activity. The text will provide you with a number to call and secure your account. Once you call this number you will be asked to verify your home address and social security number for identification. Amidst the flurry of your Black Friday or Cyber Monday shopping spree, you could get tripped up and provide a hacker with all of the information that he/she needs to steal your identity, access your financials or worse.
Operational due diligence meetings have become impactful moments for hedge funds to impress both current and potential investors. Firms have the ability to answer questions, alleviate fears and market themselves in a one-on-one setting that affords more opportunity than a completed due diligence questionnaire and an up-to-date performance sheet.
But how can today’s hedge funds truly set themselves apart and impress investors during these ODD meetings? Here are five ways:
1. Demonstrate your knowledge of and commitment to regulatory compliance.
Increasing regulatory oversight of investment firms has been a consistent trend over the course of the last few years, and it can be a challenge for hedge funds to keep abreast of changing legislation and regulator expectations. Disclosure and reporting requirements under the Investment Advisers Act of 1940, record-keeping requirements under the Dodd-Frank Act, and growing cybersecurity recommendations as part of the SEC’s ongoing inquiry are just a few of the initiatives to keep track of. But demonstrating to investors that your firm has knowledge of these regulations and takes them seriously will serve you well.
Whether your firm is compliant to the SEC, FINRA, NFA, CFTC, FCA – phew! – or another regulatory body, it’s imperative that you take the time to fully understand your firm’s legislative requirements and, in writing, show investors your level of preparedness. For example, if you’re a registered investment adviser with the SEC, are you aware of the proposed rule that would require firms to implement business continuity and transition plans? Have you compiled a document that outlines the SEC’s 28 points identified in its cybersecurity risk alert? Coming to your next investor due diligence meetings with this knowledge and the appropriate documentation will demonstrate that you take regulatory compliance seriously and are equipped to comply with the necessary requirements facing your organization.
To wrap up and round out our 6-week Risk Outlook Webinar Series, we spoke with John Cotronis, Executive Director at JP Morgan, about hedge fund risk management and governance. Specifically, he addressed the following questions:
What have you observed in recent years in terms of changes affecting hedge funds – particularly at the startup phase?
Have you noticed a marked shift in the importance managers are placing on risk?
Do the firms you typically engage with have staff on hand to manage risk – compliance officers, etc.?
In terms of corporate governance, where do you see investment firms excelling when it comes to implementing risk management controls and also fostering a culture of risk management across the firm?
Let’s talk a little bit about counterparty risk. What kind of criteria are you looking for that indicates to you a provider has the right risk management framework and best practice structure to support your clients?
A lot has gotten tougher for firms, particularly on the investment side with capital raising, also with regulatory reporting, etc. What areas of operations do you think have gotten easier for hedge funds over the years?
What is your assessment of outsourcing risk – is it higher or lower than managing various functions in-house?
As our Risk Outlook Series continues, we recently spoke with John Araneo, Partner at Cole-Frieman & Mallon LLP in New York, about many of the regulatory risks facing hedge funds today, including compliance, expense allocations and cybersecurity. Continue reading for a brief synopsis or scroll down to watch our webinar replay below.
How would you describe the current regulatory climate for fund managers and investment advisers?
For hedge fund managers and investment advisers, the regulatory expectations have never been higher. Looking ahead to 2017, managers and advisers should expect the challenge of having to navigate potentially seismic regulatory changes - each of which has the potential to complicate business practices and add to the cost and complexity of compliance.
How should clients prepare to react to these changes?
It’s a top-down approach that all comes down to compliance. A culture of compliance is no longer a lofty goal or a cliché; it is now a regulatory expectation. There needs to be a robust compliance program, actual implementation, and accountability. Clients should be prepared and able to effectively manage the SEC examinations. Managers need to take time to understand regulatory priorities and expectations before an exam.
What is the current regulatory regime's appetite for outsourcing the compliance function?
There is no requirement for firms to employ a full-time person to service compliance. However, the worries about outsourcing certain functions, particularly the compliance officer function, may lead to weakened compliance culture. The opportunity of outsourcing creates a gap between the compliance function and the operations, decision makers and day-to-day activities. Outsourcing can be effective and sufficient, but management needs to resist setting it and forgetting it.
During Part 2 of our Risk Outlook Webinar Series we spoke with Eze Castle Integration Director Dan Long about how investment firms should address evolving cybersecurity risks, third party service provider oversight and employee training and education. Many of the points Dan addressed highlight questions hedge funds and private equity firms should be asking themselves.
Read on or scroll to the bottom to watch the full, 30-minute replay.
What is our commitment to cybersecurity and what is our outlook on the future?
Regulators and investors continue to ask more questions about cybersecurity because they want to know that firms are effectively mitigating risk. To meet these growing expectations, firms must demonstrate that you take cybersecurity risk seriously and have implemented sound systems, policies and procedures to combat those risks. As the threat landscape and technology continue to evolve, investment management firms need to evolve accordingly and develop better ways to counteract threats. Firms don’t necessarily need to implement every available security technology, but they should be keenly aware of their options and have a plan to effectively mitigate as much risk as possible.
How are we addressing third party risk and oversight?
Investment management firms often rely on third party vendors to obtain functionality or capabilities that they need, want or can’t afford to produce on their own. But moving functions out of the firm's control can present challenges. With any outsourced function, the firm inherently takes on additional risks at the hands of the third party. But it's critical for investment managers to limit those risks through sufficient due diligence. To combat vendor risk, financial firms need to maintain strict oversight of all third party relationships and investigate security practices and protocols, particularly for those vendors who have access to the firm's confidential information. An outsourced vendor should be providing the same level of security (or better!) as your firm would if the function was under in-house control.