New York (HedgeCo.net) – Hedge funds need to enhance the way they manage key contracts in order to meet today’s stricter standards of risk management and reporting and prepare for the future. Fortunately, this challenge is easier to meet than you might think.

Several factors are pushing risk management and reporting standards onwards and upwards:

• Regulatory initiatives. While uncertainty surrounds how far new regulations will go, it seems inevitable that there will soon be greater regulatory oversight of hedge funds and other private funds in the United States, Europe and elsewhere.
• Industry best practice. Statements by industry groups such as the Managed Funds Association (MFA), the Alternative Investment Management Association (AIMA) and the Hedge Fund Standards Board (HFSB) emphasize the need for effective risk management (including stress tests, scenario analyses, disaster recovery, etc) and greater transparency between hedge funds and their regulators, counterparties and investors.
• Awareness of risk. If nothing else, the financial crisis demonstrated again that the world is unpredictable and unforeseen things can happen and cause unexpected consequences. It is now quite common to hear people say that their hedge fund started worrying about counterparty risk for the first time in 2008.
• Investor scrutiny and reputation. Investors are now showing far more interest in finding out what risks hedge funds are exposed to and how they manage them. The MFA’s Model Due Diligence Questionnaire for Hedge Fund Investors contains the following section on risk management: “Please describe the firm’s risk management philosophy and discuss the approach used by the firm in the management of the fund’s exposure to: equity, interest-rate, currency, and credit market risk (as applicable); financing and counterparty risk; and operational risk”. In today’s environment, those who are not among the leaders in risk management may find it harder to attract and retain investors and they are putting their reputations at risk.

If it was not already, effective management of liquidity risk, counterparty risk and operational risk has become a top priority. Moreover, effective management of each of these risks depends upon effective management of the terms of key financial trading contracts such as ISDA Master Agreements and ISDA Credit Support Agreements. And, particularly when it comes to complex contracts like these, “effective management” today means much more than it might have meant before the financial crisis.

As the MFA’s 2009 Sound Practices for Hedge Fund Managers states: “the fact that OTC derivatives are individually negotiated transactions that can have unique characteristics and terms makes them especially challenging to manage from an operational and business perspective”. Accordingly, the MFA encourages fund managers to consider taking actions such as “implementing appropriate systems to record the material terms of all OTC contracts to facilitate the appropriate pricing and risk management of these portfolios” and “reviewing counterparty OTC margin calls and instituting a process for assessing when the Hedge Fund Manager should make its own OTC margin calls to brokers, as appropriate.”

Today, effective management of contract risks requires sophisticated real-time analytical and reporting capabilities, not just squeaky filing cabinets, questionable PDF scans and an Excel spreadsheet. For the following reasons, these traditional methods of documentation risk management fall short of modern requirements and are also a false economy.

Deficiencies of Traditional Methods

Traditionally, market participants have managed post-execution contract risk by relying on original hard copies or scanned copies of contracts and, sometimes, a manually completed summary of terms, perhaps in a spreadsheet.

When something comes up and a contract portfolio is small, sometimes it is simple enough to locate an original agreement and find the relevant provisions. But with contracts as complex as ISDA Master Agreements and ISDA Credit Support Agreements, the portfolio does not have to be very large before this becomes unwieldy and an inefficient use of resources. And, while a spreadsheet of terms may be helpful, spreadsheets are rarely as detailed, accurate, consistent and up to date as one would like. Hence reliance on traditional methods usually means that repetitive, time-consuming manual review exercises are unavoidable. Even with a small portfolio, proactive portfolio contract risk management is neither easy nor cost-effective using a traditional approach.

Limitations of spreadsheets:

• high-level, limited coverage: no help for unanticipated issues
• data separated from original text: no direct way to access original text or verify data
• manual input of data: variable quality and consistency, cannot be relied upon in critical circumstances (e.g., close-out)
• difficult to maintain or expand as contract portfolio grows and new issues arise
• do not facilitate easy portfolio analysis and stress testing; can only (hopefully) help with reactive risk management

The limitations of traditional methods not only impact on a hedge fund’s ability to manage its contract risks and in turn its liquidity, counterparty and operational risks. They also impact on its general operational preparedness and agility, which has broader implications for its ability to take advantage of good business opportunities and react to new circumstances in fast-moving markets.

New Approach

Fortunately, there is now a cost-effective solution that offers the type of dynamic contract analysis and reporting capability that enables hedge funds to meet the challenges of the new era and beyond.

It requires very little effort on the part of hedge funds and the concept is simple enough, even if it is difficult to describe what is a technology-enabled service without using just a little technical language.

The service is called docGenix inSight, and there are two elements to it. Firstly, the computer-aided transformation of executed contracts into a structured format based on a widely used open-source computer language, Extensible Markup Language (XML). The resulting XML documents look just like the original contracts, but alongside each paragraph of original text is an embedded data summary. Once the contracts are in this format, they are hosted on a secure docGenix Synopsys website that gives subscribers 24/7 online access together with a suite of sophisticated analytics and reporting capabilities.

While this offers an ability to access and search text (including across an entire portfolio), the most powerful capabilities are made possible by the highly granular XML data that is added during the conversion process. Critically, the data is structured and standardized. Equivalent provisions are described using the same data values, ignoring non-substantive textual differences. For example, the phrases “below BBB+” and “to BBB or below” found in ratings downgrade provisions are both tagged with the data value “BBB”. At the same time, data values are put in context (for example, a data value of “USD” might be tagged as a “Termination Currency”).

This work “under the hood” offers a number of advantages and opens up a new world of possibilities:

• very comprehensive, high quality and consistent data
• a long-term solution: flexible XML models and structured data tagging mean that approach is efficient to maintain or expand in response to a changing environment
• data sits alongside original text: provides on-hand ability to access and search text of original contract and to verify data
• can conduct precisely targeted searches to find exactly what is wanted
• can conduct searches across a range of values at once. For example, can stress test contractual terms by finding all provisions that would be triggered by a decline in NAV (excluding redemptions) of up to 20% in a one-month period and see the consequences
• can extract provisions of a particular type and, if desired, compare them against each other or against a template
• flexible reporting for management, investors, regulators and others. Those who want an Excel spreadsheet can have one – as well as reports in other formats like (easy to read) HTML or PDF. Reports can be personalized and tailored for different audiences – it is easy to select particular data fields for inclusion in a report and change the selection at any time. And they can be automatically updated without manual effort
• can use data to feed other systems automatically (such as a collateral system or a NAV monitoring, analysis and reporting system such as the one docGenix will be bringing to market shortly)

The secure online storage of contracts also provides subscribers with valuable disaster recovery benefits. But the best news of all is that these capabilities and advantages offer hedge funds ongoing cost savings.

Those who are adopting a solution like this are not only responding to the new regulatory and best practice environment. They are also preparing their businesses for the commercial, legal and regulatory challenges of the future and making a powerful statement that they are serious about risk management and want to be seen as leaders in the class, not believers in the adequacy of the status quo.

If you would like more information about docGenix or docGenix inSight, visit www.docgenix.com or send an email to info@docgenix.com.

John Berry is General Counsel of docGenix, L.P.