Transcript Slide 1

Thomas G. Kennedy
Chief Compliance Officer
Fiduciary & Investment Risk Management Association
23rd Annual National Risk Management Training Conference
Managing Counter-party Risk
April 30, 2009
The views presented herein are those of the presenter and do not
necessarily represent the views of Arden Asset Management LLC.
This presentation should not be considered tax, legal or investment
advice.
AGENDA
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Managing risks in structured products and OTC derivatives distributed
through wealth management platforms.
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Managing brokerage counterparty risks discretionary accounts.
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Managing sub-manager risk in products where manager or hedge fund
selection is the basis of the product.
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Conclusion.
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STRUCTURED PRODUCTS
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Manufacturer, Issuer, or Soliciting broker….any or all of these could be the
source of an investor’s counterparty risk.
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Bank A creates a Buffer Note on Crude Oil, issued by Bank B, and
distributed by the wealth mgmt business of Bank C.
– Where’s the investor’s counterparty risk?
– What are the responsibilities of Bank C, the distributor?
– Is there fiduciary risk involved?
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Bank A creates the same note, but this time uses a Special Purpose Vehicle
in Luxembourg to issue the note. The SPV does a total return swap with
Bank B. Bank C is still the distributor.
– How has the counterparty risk changed?
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STRUCTURED PRODUCTS (continued)
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Proprietary products versus open architecture
– Best execution.
– Complexity for investor and distributor.
– Risk disclosures, client suitability.
– Screening eligible third party issuers (agency ratings, CDS, quality of
service, transactors, trading ideas, pricing).
– Distribution agreements.
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OTC DERIVATIVES
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Wealth management clients may transact any of the following OTC
derivatives, as hedgers or speculators:
– Interest rate swaps
– Credit default swaps
– FX forwards or options on almost any currency pair that is tradable
– Commodity or commodity index options
– Equity options
– Hedge fund options
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Governing documentation is ISDA, along with a Collateral Security
Agreement, since most are transacted on margin.
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Investors in many wealth management firms take counterparty risk of the
firm itself. Under open architecture, the firm may buffer the professional
third party risk, and leave the retail investor only with their own performance
risk. An option is to have the investor face the third party’s counterparty risk.
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OTC DERIVATIVES (continued)
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Measuring the counterparty risk of OTC derivatives
– Full-life (of the underlying swap or option) pre-settlement exposure,
PSE
– Estimates the maximum likely change in value, to 2 std dev, with
volatilities based on the highest of 6-month historical, 3-yr historical or
current implied
– 1-year forward USD-Euro would have a PSE of 10% of notional amt
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Wealth management clients do not recognize counterparty risk bilaterally as
professional counterparties do; its one-sided, banks require clients to
maintain margin collateral to the extent of PSE.
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Margining rules vary; a common approach for trading clients is to use 2 std
deviations for a 1-week period of risk, rather than full life PSE, which could
be several times larger. 25% margin erosion (mark-to-market loss) leads to a
variation margin (top-up) call to be met within a day, 50% erosion results in a
position sellout.
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DISCRETIONARY MANAGED PORTFOLIOS
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Investment managers may use one of several ‘approved brokers’ on their platform to
execute equity or fixed income trades for client accounts.
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But who bears the cost if one those (counterparties) brokers fails?
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Clearing members of major exchanges will be supported by the other members; real
counterparty risk lies with OTC principal trades, as with many fixed income and small
cap equity transactions.
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Split expectations:
o The manager will claim to operate on best efforts of reasonable due
diligence, and leave the client with the loss.
o Clients will claim the manager has a fiduciary duty to hold them harmless.
o And the investment management agreement is typically silent on the issue.
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Ideally, the IMA should contain a named list of authorized brokers, or a minimum
public rating standard.
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Investment manager due diligence for vetting brokers may include public ratings,
credit default swap levels, background checks, regulatory filings.
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INVESTMENT MANAGERS AND ADVISERS
Guidelines for Selecting Investment Managers and Advisers
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Delegation of investment authority to a third party is a matters of fiduciary
judgment and discretion and require the exercise of care, skill, and caution.
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At a minimum, a fiduciary manager should obtain full information on an
investment firm’s investment and business approaches, professional resources,
financial strength, historical performance, regulatory history, personnel turnover,
comparative fees, and other relevant factors.
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Fiduciary managers should review the following items when considering
investment firms for providing investment management and advisory services.
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MANAGER SELECTION: THE CASE FOR DUE DILIGENCE
• Exposure to fund manager failures or blow ups can occur due to improper
planning or outright fraud.
• Undisciplined or misunderstood investment or risk management techniques
used by 3rd party managers can lead to risk.
• Poor internal controls allow for errors and potentially fraud to occur.
• Conversely a strong, scaleable infrastructure allows a manager to grow and
support new products, assets, and financial instruments.
• Lack of adequate infrastructure or use of second rate service providers can
impede the investment program of an otherwise sound manager.
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WHY CONTINUALLY MONITOR MANAGERS?
Fund managers are constantly evolving…
• Continuous monitoring is imperative to keep track of key changes within the
firm, such as staff changes, IT/system implementations, strategy/product
changes, rapid growth, service providers relationships, etc.
• New strategies and/or securities and market risks give rise to new
opportunity, but also risk and challenges.
• New legislation, regulatory or accounting rule changes constantly reshape
organizational functions.
• Managers are more likely to rectify deficiencies when forced to address them
with investors.
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OPERATIONAL DUE DILIGENCE
• Due diligence reviews can be helpful to the manager.
• Deficiencies may be noted and communicated to the manager:
– The manager is given the opportunity to improve operational control
deficiencies.
– Depending upon severity of the issues, initial investment can be denied or
postponed pending resolution of deficiencies noted.
– Managers appreciate the feedback and are typically keen to understand what
others in the industry are doing.
– Most managers want to adhere to best practices.
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Third Party Manager Selection
Three-pronged
approach
to 3rd party manager
selection
Investment and
Quantitative Research
Operational
Due Diligence
Service Provider
Due Diligence
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FIRM BACKGROUND AND INVESTMENT EXPERIENCE
• Ascertain date established, ownership, affiliations.
• Evaluate inception date of and types of investment products and
investment strategies/styles used (taxable and non-taxable).
• Understand amount of fully discretionary assets under management,
trends.
• Understand client base demographics.
• Evaluate:
Procedures for best execution/soft dollars
Who makes investment decisions
How securities are selected
The firm’s normal portfolio turnover
How are portfolios monitored for consistency with client needs and
circumstances
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− Where is research developed (internally or externally)
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INVESTMENT MANAGEMENT PERSONNEL EXPERIENCE
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Obtain and evaluate biographical sketches of senior firm staff involved in
− Portfolio Management.
− Trading
− Research/Analysis
− Others with significant responsibilities in the firm.
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Evaluate experience of investment staff by investment product and style.
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Evaluate names and role of third-party service providers used in investment
process.
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INVESTMENT PERFORMANCE AND RISK METRICS
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Review short and long-term investment performance for applicable styles,
including dispersion information among portfolios.
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Ask how performance is calculated and whether performance results are audited.
Ascertain GIPS verification.
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Examine the firm’s process for developing benchmarks and assessing
performance against established benchmarks.
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Evaluate quantitative metrics and diversification guidelines or concentration limits
for the following factors (Countries/currencies, Industry sectors, Issuers,
Securities, Capitalization, P/E, price-to-book ratios).
− How does the firm manage leverage (portfolio borrowing and derivative
usage).
− How does the firm monitor fixed income quality, duration, return, and
distribution.
− What risk measurement and reporting systems do they use?
− How does the firm manage style drift?
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COMPENSATION/ FEES/ LIQUIDITY/ CUSTOMIZATION
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Evaluate fee schedules. Will the firm negotiate fees?
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Does the firm manage separate accounts? If so, what is the minimum size?
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Will the firm aggregate assets when calculating fees for accounts related to a
single investor/family?
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Does the firm have a hurdle or high watermark for incentive fees?
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Is there a lock-up period?
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How early does a withdrawal notice have to be received?
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Has the firm ever exercised the option to forbid investors from withdrawing from
a fund?
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REPORTING CAPABILITIES
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Review Form ADV, an IM agreement, an offering memorandum, a subscription
document, and a schedule K-1 for the product or strategy.
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Understand what client reporting is available including capability and time frames.
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Ascertain whether prices and positions reconciled with custodians.
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Understand and sample what type of market and portfolio commentary does the
firm provide to clients and consultants, and how quickly does the firm provide it
after the end of a period.
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Determine if the firm provides after-tax return spreadsheets.
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BUSINESS OPERATIONS AND INFRASTRUCTURE – POINTS TO EVALUATE
• Hiring processes, staffing and
personnel
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•Evaluate transparency, i.e. does the firm
provide access to tax-lot accounting
information?
• Insurance coverage.
•Service provider relationships, counterparty
relationships and associated agreements.
• Pricing and valuation process,
controls & methodology of
securities.
•IT and systems platform, disaster
recovery/business continuity planning.
• Internal compliance and audit
programs and regulatory
registrations.
•Trading & reconciliation process and
controls, & custodial controls over assets
and cash management policies.
•Financial audits on the firm and products,
fund accounting, audit & tax management
• Current or past judgments, litigation,
or regulatory actions against the firm
or its employees.
• Does the firm have contingency
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OPERATIONAL DUE DILIGENCE
• Suggested components of due diligence program:
– An onsite due diligence meeting.
– Review of legal documentation and other manager material.
– Background checks.
– Review of regulatory & corporate registrations.
– Service provider verification.
– Manager reference calls.
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MONITORING METHODS
• Monthly calls.
• Annual onsite due diligence update meetings.
• Review of manager communications, such as monthly or quarterly letters
announcing organizational changes & updates.
• Word of mouth through industry contacts.
• Industry literature, newsletters, and other periodicals.
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SERVICE PROVIDER DUE DILIGENCE
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Service providers are a critical element to the operations and success of
hedge fund manager.
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Independently verify key service provider relationships for new managers.
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Fund administrator, prime brokers/custodians, auditor, valuation consultants,
rating agencies, and IT/software providers.
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Perform due diligence on service providers.
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IN CONCLUSION
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Counterparty Risks not limited to Institutional Businesses alone
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Wealth management investors should become more aware of their
counterparty risks in structured products, OTC derivatives and managed
account portfolios
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Events of the past two years, and especially the LEH bankruptcy, have
heightened the awareness of counterparty risks even among professionals,
whether in interbank options/swaps or prime broker margin businesses
serving hedge funds
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Efforts are underway to unravel the USD tens of trillions of derivatives
counterparty risk, esp credit default swaps, via clearing house mechanisms
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Manager selection risk has always been critical in light of spectacular
manager blow-ups and more recently, there is an emphasis on operational
due diligence aspects in light of the Madoff fraud.
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Expect regulatory expectations and industry best practices to change.
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REFERENCES
OCC Asset Management Handbook
MFA Sound Practices for Hedge Fund Managers
PWG Asset Manager and Investor Committee Reports
AIMA Guide to Sound Practices for European Hedge Fund Managers
HFSB Hedge Fund Standards
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IMPORTANT DISCLOSURE INFORMATION
The views presented herein are those of the presenter and do not necessarily represent the views of Arden Asset Management LLC.. The
accompanying material is was intended for information purposes only, and does not constitute a description of Arden’s investment or risk
management processes. In addition, the opinions, forecast, assumptions, estimates and commentary contained in this presentation are based on
the presenter’s varied experience and provided on an informal basis. This presentation should not be considered tax, legal or investment advice
Further, any opinions, forecasts, assumptions, estimates and commentary are made only for information, and are subject to change at any time
without prior notice. Nothing herein constitutes an offer to sell, or solicitation of an offer to purchase, any securities, nor does it constitute an
endorsement with respect to any investment area or vehicle.
The presenter has no obligation or responsibility to update or supplement these materials. No warranty is given as to whether any information
contained herein is current and the presenter assumes no obligation or responsibility for the accuracy of the information. Some information
contained herein has been obtained from third-party sources, and such information has not been independently verified. No representation,
warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information contained in this material; no
reliance may be placed for any purpose on such information; and no liability is accepted by any person for the accuracy and completeness of any
such information.
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