Mar. 29, 2018

Six Essential Technology Articles for Private Fund Managers

Private fund managers have an increasing number of emerging technologies at their disposal that can be leveraged to enhance compliance with regulatory requirements, streamline administrative processes or generate heightened returns. For example, while the fervor toward blockchain has diminished since the end of 2017 due, in part, to the precipitous decline in cryptocurrency prices, that technology continues to present opportunities for private funds and their service providers. Nevertheless, new technologies also present several challenges, as the SEC and other regulators increase their scrutiny of them given concerns related to privacy and cybersecurity, among others. In recognition of these industry trends, the HFLR is highlighting six articles from its historical archives that provide guidance on critical technological issues facing private fund managers. Next week (the week starting April 2, 2018), the HFLR will resume its normal weekly publication. Note that William V. de Cordova, Editor-in-Chief of the Hedge Fund Law Report, will be moderating a panel on the use of big data by fund managers at the upcoming GAIM Ops Cayman conference in late-April 2018. For more information about the conference, click here. To register for the conference, click here, using the HFLR’s promotional code available in this article for a 10-percent discount. See also our three-part series on big data in the investment management industry: “Its Acquisition and Proper Use” (Jan. 11, 2018); “MNPI, Web Scraping and Data Quality” (Jan. 18, 2018); and “Privacy Concerns, Third Parties and Drones” (Jan. 25, 2018).

Blockchain and the Private Funds Industry

Blockchain is frequently mentioned as a transformative technology with the potential to disrupt the private funds industry. Given the frequency and reverence with which it is mentioned, at first glance it appears that blockchain technology is already widely used in the industry. Upon closer inspection, however, it becomes clear that widespread uncertainty persists about what blockchain even entails, not to mention where the technology currently stands and how it could plausibly be used to improve private fund operations. To help our subscribers understand the status of blockchain technology and its potential to aid the private funds industry, this three-part series serves as a primer about the technology and its interplay with the private funds industry going forward. The first article provides an overview of how blockchain functions and examines how the finance industry is already utilizing it. The second article describes potential ways private funds and service providers can adopt blockchain technology to enhance fund operations and compliance practices. The third article explores some of the risks impeding the growth of blockchain and addresses the most plausible timing and manner for it to be eventually adopted in the industry. For more on blockchain, see “Private Fund Advisers and Service Providers Must Evolve Their Businesses to Keep Pace With Innovations in Technology, or Risk Becoming Obsolete” (Jan. 18, 2018); and “How Blockchain Will Continue to Revolutionize the Private Funds Sector in 2018” (Jan. 4, 2018).

Managing the Machine: How Hedge Fund Managers Can Examine and Document Their Automated Trading Strategies

Over the past few years, financial regulators have been urging firms that execute automated trading (AT) strategies to implement policies and controls reasonably designed to prevent market disruption by that trading. The recast Markets in Financial Instruments Directive (MiFID II), which went into effect earlier this year, ushered in new restrictions for algorithmic traders. FINRA and several industry organizations have also begun to fill in the gaps on the U.S. equities side by issuing detailed guidance covering everything from pre-trade controls to system documentation procedures. Last, but not least, in November 2015, the CFTC proposed a new rule entitled Regulation Automated Trading (Regulation AT), which calls for the adoption of risk controls, transparency measures and other safeguards to strengthen the regulatory regime surrounding AT. In this two-part guest series, Douglas A. Rappaport and Elizabeth C. Rosen of Akin Gump outline five high-level first steps for legal and compliance professionals to design and implement a control framework tailored to a hedge fund manager’s AT program that will stand up to regulatory scrutiny. The first article covers steps one and two, including a discussion on how to conduct a risk assessment of and document the AT system. The second article explores the remaining steps, addressing protocols for monitoring and reviewing trading activity, source code and disclosures. While Regulation AT has not yet been adopted, this article remains required reading for any fund manager pursuing AT in light of the actions taken by other regulatory bodies, as well as the general expectation that those managers have policies and procedures tailored to the risks associated with that form of trading. For more on how MiFID II regulates AT, see “FCA Outlines U.K. and MiFID II Requirements for the Development, Testing and Operation of Algorithmic Trading Systems” (Mar. 1, 2018); and “ACA Panel Reviews Effects of Impending MiFID II on U.S. Advisers” (Dec. 7, 2017).

Key Considerations for Hedge Fund Managers in Evaluating the Use of Cloud Computing Solutions

Investors increasingly expect hedge fund managers to have best-of-breed technology and applications designed to, among other things, conduct business effectively and efficiently; safeguard the firm’s data; and facilitate compliance with applicable regulations and investor demands. These expectations pose an obstacle for many hedge fund managers because of the significant costs required to implement and maintain a robust technological infrastructure. Cloud solutions have helped to partially alleviate this burden by making numerous applications and functions available online, thus reducing or eliminating the need for a firm to establish and maintain heavy technological infrastructure, as well as the capital, personnel and real estate costs associated with that infrastructure. While particularly attractive for smaller hedge fund managers wishing to minimize the amount of launch capital spent on technology, cloud solutions have also become attractive to larger, more well-established managers seeking cost-savings and other benefits. This two-part series discusses cloud computing solutions for hedge fund managers. The first article defines cloud computing services; outlines key differences between different types of cloud computing solutions; describes the functions available through cloud solutions; and highlights the benefits and risks of using cloud solutions. The second article discusses how to evaluate the various cloud computing solutions and providers; describes best practices in creating and implementing policies and procedures for using cloud solutions; and identifies common mistakes made by hedge fund managers in selecting and using cloud solutions. For more on working with cloud service providers, see “Key Considerations for Fund Managers When Selecting and Negotiating With a Cloud Service Provider” (Sep. 21, 2017).

Key Elements of Electronic Communications Policies and Procedures for Hedge Fund Managers

Electronic communications technologies – such as phone, email, instant messaging and social media – are essential to the efficient operations of hedge fund managers. They also pose considerable regulatory, litigation, reputational and trading risks, however, and can lead to the downfall of a manager if not properly handled. Moreover, electronic communications are among the most difficult categories of information to contain; they are indelible, are pervasive and often determine the outcome of private and government litigation. Yet more often than not, these communications are drafted under the mistaken impression that they are as easy to erase as they are to create. Despite a lengthy list of cases illustrating the fallacy in this notion, hedge fund manager personnel continue to create and send electronic communications that fail the commonly used litmus test: “If you wouldn’t want it on the cover of the Wall Street Journal, don’t send it.” This article seeks to assist hedge fund managers in creating, refining and enforcing electronic communications policies and procedures by cataloguing the various types of electronic communications technologies used by hedge fund manager personnel, as well as the categories of communications that may be created with those technologies; identifying specific risks arising out of the various communications and technologies; and outlining the key elements of electronic communications policies and procedures. For more on electronic communications, see our three-part series: “SEC Takes Steps to Drill Drown” (Nov. 30, 2017); “Information Request List Provides Insight Into SEC Expectations on Their Use by Advisers and Employees” (Dec. 7, 2017); and “Six Key Issues to Address in Electronic Communication Policies and Guidance on Preparing for Future Scrutiny” (Dec. 14, 2017).

Can Emerging Hedge Fund Managers Use Technology to Satisfy Business Continuity Requirements and Mitigate Third-Party Risk?

Hedge funds are investing in sophisticated and robust infrastructures and information technology (IT) services to stay ahead of competition and drive growth in a changing marketplace. Challenges await, however, particularly for startup firms with budget restrictions, tight timelines and short resumes. New launches will have to raise their standards to ensure IT systems and technology support structures are in place to give firms an edge where perhaps other operational areas cannot. In this guest article, Vinod Paul, former managing director of Eze Castle Integration, examines considerations for emerging hedge fund managers in establishing technology infrastructure – including components to ensure resiliency of the manager’s business – and discusses ways an emerging manager can avoid common startup pitfalls. For more on managing third-party service providers, see “Fund Managers Must Supervise Third-Party Service Providers or Risk Regulatory Action” (Nov. 16, 2017).

What Concerns Do Mobile Devices Present for Hedge Fund Managers, and How Should Those Concerns Be Addressed?

Mobile devices, such as smartphones and tablet computers, have significantly enhanced the abilities of hedge fund managers and their personnel to conduct business more effectively and efficiently by, among other things, facilitating performance of job functions outside of the office. These productivity gains, however, come at a cost. The ability to remotely access firm networks and information via mobile devices magnifies the risk of losing control over access to firm information and systems. This loss of control can, in turn, create additional perils, most notably, security concerns for hedge fund managers who closely guard any informational advantage they have over competitors. Additionally, this loss of control may heighten risks that a firm’s network is compromised, which can cause significant damage to a firm’s operations. Therefore, it is imperative that hedge fund managers keep up with the ever-growing risks that arise from the rapidly evolving mobile device technology landscape and adopt policies and solutions designed to minimize the loss of control over access to firm information and systems. This three-part series addresses the concerns raised by mobile devices and outlines policies and procedures, as well as technology solutions, that can help hedge fund managers mitigate the risks posed by the use of mobile devices. The first article provides an overview of the use of mobile devices, including how hedge fund managers have historically addressed that use, and outlines the risks raised by mobile devices, including security risks; risks related to unauthorized trading; and concerns relating to retention and archiving of books and records. The second and third articles discuss principles and detail best practices for establishing mobile device policies and procedures, as well as specific mobile device solutions and technologies designed to address the risks catalogued in the first article. For more on how fund managers can protect against breaches, see our two-part series “The Challenges and Benefits of Multi-Factor Authentication in the Financial Sector”: Part One (Nov. 2, 2017); and Part Two (Nov. 9, 2017).

Upcoming HFLR Webinar to Explore Regulatory Considerations of Private Funds Investing in Cryptocurrencies

Please join Hedge Fund Law Report on Wednesday, April 11, 2018, at 11:00 a.m. EDT, for a complimentary webinar discussing some of the emerging regulatory trends concerning cryptocurrencies, including the role of gatekeeper being played by the SEC and the challenges in applying regulations that were designed for more traditional asset classes to cryptocurrencies. The webinar, entitled “Cryptocurrency and Private Funds: What Investors and Managers Need to Know About Emerging Regulatory Trends,” will be moderated by William V. de Cordova, Editor-in-Chief of the Hedge Fund Law Report, and will feature Karl Cole-Frieman, founding partner of Cole-Frieman & Mallon, and Lee Schneider, partner at McDermott Will & Emery. To register for the webinar, click here.