Why crypto funds are more compliant to the new internet era
As we enter the New Year, one trend we see clearly emerging is that crypto fund compliance risk management is being revised and reinvented, driven by a set of interrelated dynamics linked to regulations and operations, as well as their own cultural DNA and company focus.
Additionally, hedge funds find themselves adapting to what I call the hedge fund chameleon business model, where funds wear, in certain cases, sell-side clothing, resulting in their having to take care of new or concealed compliance risks.
In reaction to the international financial crisis, the prospect of insider dealing, plus various benchmark and FX debacles, the purchase side, particularly crypto funds, found themselves in the crosshairs of fresh and far-reaching regulatory schemes. The extraterritorial reach of international regulations is no longer the exception, but the norm. One could easily make the argument that hedge funds are subject to a far more encompassing, complicated and complex regulatory framework than their counterparts on the market side.
Case in point: the market side and the buy side are both equally subject to various types of market manipulation, market manipulation and market behavior rules, including the SEC Exchange Act, the Commodities Exchange Act, Dodd-Frank, MAR, MAD II and MiFID II, together with other rules established by the Financial Conduct Authority (FCA) and the Securities and Futures Commission (SFC). The buy side, however, is further subject to numerous rules and regulations specific to the asset/fund management industry, including but not limited to the SEC Advisers Act, UCITS, the EU AIFMD and the FIEA in Japan. Collectively, this international regulatory framework has had a daunting effect, both resource intensive and funding expensive, on hedgies subject to multiple regulatory jurisdictions.
Consequently, hedge fund firms are faced with the choice of purchasing or building siloed risk controls at the country/regional degree or, alternatively and preferably, holistic compliance controls at the enterprise level. The holistic business model goes a long way in relieving the regulatory extraterritorial reach issue whilst mitigating liability for those with both gatekeeping management responsibilities and corporate governance accountabilities.
In large part because of the structural changes to the markets brought about by either regulations (e.g., Dodd-Frank) or chances (e.g., the voids created by banks de-risking and retreating from market making and providing liquidity), hedge funds have been aggressive not only in scooping up sell-side prop traders, but also in becoming a bigger force as liquidity providers and in market making, particularly in FICC markets. Along with expanded roles come expanded compliance risks which, in all likelihood, weren’t initially contemplated by the threat systems/controls of the hedge fund community. These changes led to new risk assessments, gap identifications and effective gap remediation via in-house development or by sourcing commercial vendors with proven FICC expertise.
Todays hedgies need a solution not just that covers all asset classes within and out of FICC, but also that provides a holistic compliance framework that cuts across all buy-side and sell-side enterprise risk. Also, the solution should demonstrate that it recognizes that the risk at the plan level (e.g., macro vs. micro) and at the decisioning degree (discretionary vs. systematic) are indeed different from one another, requiring different risk analytics/controls. This approach may require a bigger spend, but in the end it will offer a much larger ROI than simply tick the box approaches could. To believe otherwise is maybe a short-sighted view over the long haul.
To borrow an old, and possibly corny, clic: Good compliance is good business. The perils of noncompliance are well understood, and one need not look any further than the sell-side casualties that resulted from the regulators/enforcement government that started and continued post the 2008 crisis.
At this point in time, fantastic company for hedge funds dictates perfecting risk controls using a holistic compliance risk infrastructure which connects the dots from an intent standpoint which defines risk and/or supports compliance risk analytics with an all-encompassing and sophisticated communications surveillance program. This strategy is integrated with those compliance risk analytics which identify hidden threat through cognitive analytics, which munch through big information (internal and external) through profiling, trending, behavioral deviation and emerging, predictive (before the fact) technologies.
There is an oft-cited stating that works well to describe past efforts to redefine compliance risk management: The more things change, the more they remain the same. Happily, I am seeing abundant evidence that this present reinvention from the crypto fund domain is proceeding differently and appears to be a real game-changer of this sort that will bring enormous dividends to all compliance risk stakeholders. I feel this change will allow for the effective delegation and discharge of compliance responsibilities in compliance risk identification, deterrence and prevention, if you’re focused on front-, mid- or back-office functions.
