Managing Investment Compliance in a Changing Regulatory Environment

Published on March 24, 2017 by Rahul Narsian

The usage of complex products and strategies to generate higher alpha is likely to increase as investment managers tailor their offerings to meet customer requirements. Regulators will continue to identify gaps in existing laws and roll out new directives to protect investor interest; thus, the role of Compliance will need to evolve continuously.

The compliance function has become critical over the past decade– from being a reactive function defending the firm from existing risks, it is now heavily relied upon to anticipate future risks and protect the firm against them. Moreover, regulatory changes are being introduced and implemented at a pace faster than ever witnessed before. Thus, compliance officials need to stay on top of such changes, analyze the implications, and share relevant information with the business to help them take well-informed decisions. Needless to say, in today’s world, managing risk effectively is pivotal and can be a competitive advantage across all markets.

From being a reactive function defending the firm from existing risks, it is now heavily relied upon to anticipate future risks and protect the firm against them.

Within compliance, Investment Compliance (IC; also known as guideline management, mandate monitoring, portfolio compliance, etc.) is a critical function that ensures investments made by portfolio managers comply with client and regulatory guidelines. Firms have different views on where this function fits within the corporate structure– at some firms, IC is aligned to the portfolio services group, while some prefer to keep it within the larger compliance department, and some have split the function between operations and compliance, with the former merely executing processes, and the latter managing risks and regulatory compliance. Just like compliance has evolved over the past decade, IC has also grown from being a function involving simple execution of processes to comply with guidelines to one that implements enhanced controls to prevent guideline breaches in the first place. For audit purposes, record-keeping practices have also been improved significantly to demonstrate a clear flow of events in case of guideline violations.

At some firms, IC is aligned to the portfolio services group, while some prefer to keep it within the larger compliance department, and some have split the function between operations and compliance, with the former merely executing processes, and the latter managing risks and regulatory compliance.

Key evolving regulatory frameworks

The asset management industry is struggling to cope up with a number of rules emanating from multiple regulatory bodies globally. Regulators are now demanding more transparency in the entire trade flow – from order generation and booking to periodic reporting to the regulator. Some key initiatives in the European Union that are having an impact globally include the Alternative Investment Fund Managers Directive (AIFMD), European Market Infrastructure Regulation (EMIR), Undertakings for Collective Investments in Transferable Securities V& VI (UCITS), and Markets in Financial Instruments Directive (MiFID II). Similarly in the US, the Foreign Account Tax Compliance Act (FATCA), an anti-tax avoidance measure, and proposed reforms to the Dodd Frank Act will significantly impact the way firms around the globe conduct their business.

Another important aspect of regulatory changes is the cost implication – making changes to the existing infrastructure to comply with new regulations can involve huge costs. Generating alpha in this ever-changing regulatory environment is becoming increasingly difficult. Firms now have to think of innovative ways of lowering costs to minimize the impact of increased regulatory costs on the firm’s bottom-line.

Generating alpha in this ever changing regulatory environment is becoming increasingly difficult.

How are firms dealing with this?

• Consolidation – Regulatory pressures have forced firms to re-think their investment strategies and business models to ensure they are aligned with new requirements. Firms have started opting out of markets and strategies with low margins or negative returns. In terms of growing market share, firms are currently facing the dilemma of whether to continue to focus on key strengths and markets or to explore new markets and strategies. One trend that the industry is witnessing is a shift from active to passive investment – the latter is expected to have a higher market share than the former over the next few years and, hence, getting the strategy and balance right is becoming increasingly important.

• Leveraging technology – Many firms have turned toward technology to improve their existing processes to reduce redundancy. Technology enhancements require some upfront investments, but these are generally recovered in the longer run. Firms are now actively identifying tasks that can be automated using artificial intelligence. It was recently reported in MIT’s technology review magazine that a top-tier investment bank has replaced 500+ traders with machines. In another development, JP Morgan has deployed software that completes tasks in a significantly lower time than the lawyers employed by them. Click here to read the article.

• Maintaining Status Quo – Another school of thought is to view the increased regulatory changes/costs as a temporary phase that will stabilize over the coming years. Meanwhile, firms are embracing the reforms and doing their best to implement the changes and accept the reality of nominal returns until the phase passes. Smaller firms that prefer not to spend heavily on technology follow this approach.

Firms are embracing the reforms and are doing their best to implement the changes and accept the reality of nominal returns until this phase passes. Smaller firms that prefer not to spend heavily on technology follow this approach.

• Improving efficiencies – One of the main drivers of cost for every investment management firm is the cost of procuring data. Firms have been conducting a thorough review of their data sourcing/setup strategy to lower costs and optimize downstream flows to internal systems. This has helped firms improve flexibility in sourcing additional data points to automate guidelines that were historically monitored manually. This, in turn, has increased the accuracy of pre- and post-trade compliance checks by reducing false positives. Some firms resort to transferring their coding- and post-trade-monitoring-related work to other countries to leverage the time zone difference. This helps reduce the turnaround time for onboarding new clients and also gives portfolio managers ample time to rectify guideline breaches that have occurred due to various reasons. We will discuss this in greater detail in the second article of the series “Outsourcing Investment Compliance”.

• Lowering costs – Firms have been focusing on reducing existing costs to deal with the increasing costs of implementing regulatory changes. They are realigning processes to deliver more work using existing staff, reducing payouts to employees (especially top management), exploring options of setting up captives at lower-cost locations, and employing third-party service providers at lower-cost locations. Third-party firms, such as Acuity Knowledge Partners, have seen a 50-60% rise in the number of queries received about their compliance offerings. Acuity Knowledge Partners currently provides compliance services to several investment managers with cumulative assets worth more than USD 2.5 trillion.

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