Application Development
Cyber Security
Featured
Management Consultancy
OA
Author
Omar AlSharif
Read time
9 minute read
Published
15 Sep 2022
Topics
AI and Data Science
Executive summary
A focused, requirements-driven approach to a complex build vs. buy decision.
The client firm determined that a focused requirements-driven process, supplemented by stakeholder working groups, was the most rational approach to address the build versus buy decision and the subsequent design and selection considerations. The scope required the integration of a centralized risk and compliance processing module into a trade order management system platform comprising several in-house and vendor OMSs.
The existing data model was separated into distinct entities supporting reference data across the platform — including position, index, pricing, and security master (SMF) data. The client required expertise to address the following business functionality and integration challenges:
Integration of portfolio and pre-trade risk evaluation functionality into multiple OMS workflows
Centralized data process with capability maturity required for complex risk management across all instruments traded
Addition of an issuer schema to supplement the existing data model and support more robust regulatory and counterparty risk testing, including complex diversification rules
Integrated reporting to support investment management, client, and regulatory inquiry at the firm, client, fund, and issuer level
Introduction
Platform integration, regulatory complexity, and the business analysis challenge
During an investment management platform integration project, components of a firm’s order management systems (OMS), portfolio accounting systems (PAS), and data warehouse reporting tools (OLAP) are often within the scope of a business analysis effort focused on workflow optimisation and efficiency enhancements that address portfolio risk management protocols.
IT project managers and stakeholders are tasked with evaluating requirements with input from legal and compliance subject matter experts, as well as portfolio management, operations, and IT stakeholders, in order to implement complex regulatory and risk solutions. In this situation, there may be little understanding on the part of any one stakeholder group as to the best approach to the business analysis and technical requirements presented by the regulatory framework.
Common risk & compliance implementations in investment management
→Counterparty and credit risk driven by client and internal requirements
→Investment Company Act of 1940 guidelines
→Securities and Exchange Act of 1934 reporting
→Investment Adviser Act of 1940 (client guidelines)
→UCITS3 (for both alternative and traditional asset managers)
→Substantial Acquisition Rules of sovereign entities
→Internal Revenue Code reporting
The solution
A five-step stakeholder-driven requirements and implementation process
When approaching the requirements effort, there will necessarily be an extensive regulatory review in order to understand the specific testing that applies to the client’s line of business. Legal definitions and an understanding of the legislative framework are essential when working with the language of the SEC’s mandate.
Key terms
Definitions used throughout this initiative
Understanding these definitions is essential to working with the regulatory framework and data modeling requirements of a risk and compliance integration of this nature.
Investment Adviser
The “adviser” to an investment company is responsible in the legal sense for compliance to the Investment Company Act, as well as to the investment clients they represent. The adviser is often also the fund’s sponsor. Fund structures covered may include exchange-traded closed-end funds, ETFs, or open-end funds.
Net Assets
The “net worth” of the fund, expressed as a dollar amount at the fund level — as compared to NAV (net asset value), which is a per-share price struck daily. Generally includes: paid capital, undistributed net investment income, accumulated undistributed net realized gain, and net unrealized appreciation.
Total Assets
Generally includes: the sum of securities investments, cash, receivables, unrealized appreciation, and securities held as collateral for loaned securities. Expressed as a dollar amount at the fund level.
Total Market Value
As current prices are made available, this represents the market value of all positions at the fund level, expressed as a dollar amount.
Diversified Fund
A management company where at least 75% of total assets is represented by cash, government securities, securities of other investment companies, and other securities — limited in respect of any one issuer to no more than 5% of total assets and 10% of the issuer’s outstanding voting securities.
Non-diversified Fund
Any management company other than a diversified company as defined above, such as a “fund of funds.”
Senior Securities
Securities creating an obligation to someone other than the fund’s shareholders — including short sales, options, futures, forward contracts, swaps, dollar rolls, when-issued securities, and reverse repos. Prior to 1940, excessive issuance of such instruments had greatly increased the speculative nature of investment companies.
Segregated Amount
The sum of segregated quantity amounts for all positions in the account — representing the amount of cash, cash equivalents, treasury, or other liquid securities held by the custodian to cover exposure from the issuance of senior securities.
Total Issuer Voting Shares
Represents the ownership or control of an issuer, including the underlying voting rights of convertible securities, options, and warrants. “Shares of a class” comprises one class of issuer voting shares only.
Test Basket
When a specified threshold is reached with respect to a data point at the issuer level, the instance is tracked by “placing” it in a “basket” of such cases, and an exception triggered when the total basket member percentage exceeds a stated threshold relative to a predefined value such as total fund assets.
SEC Regulatory overview
The legislative framework for mutual fund compliance
There are many risk and compliance solutions that project stakeholders will be asked to advise on, depending on the firm’s line of business and the domicile of its trading activity. The four major securities acts provide the regulatory foundation for all compliance testing requirements in an OMS environment.
Securities Act of 1933
The first of four major securities acts, the ’33 Act addressed the issuance of securities — including shares of open-end and closed-end investment companies. It required that any person wishing to offer securities to the public register those securities and provide prospective investors with adequate disclosure in the form of an investment prospectus. Because mutual funds issue shares constituting publicly traded stock in the investment company itself, they fall under the provisions of the ’33 Act. The Investment Company Act of 1940 under section 35(d) states that a fund may not use a name that is misleading with respect to the investments selected by the adviser — common practice requires a monitoring system in the trade and portfolio management workflow to test for adherence to this rule.
Securities Exchange Act of 1934
The ’34 Act broadly addresses rules related to the exchange of securities. This act also created the SEC and gave it enforcement powers with respect to federal securities laws. Specifically related to mutual fund investment management, the act requires disclosure of institutional investment manager holdings, as well as provides a framework for transfer agent registration and rules of conduct.
Investment Company Act of 1940
After the stock market declines of 1929, the mutual fund industry sustained losses severely compounded by the issuance of “senior securities” used to fund adviser acquisition activity. Investor losses prompted a SEC study which determined that governance under the Securities Act of 1933 was insufficient. Congress concluded that the activities of persons operating mutual funds should be regulated under a more specifically crafted set of guidelines — the Investment Company Act of 1940.
The act establishes a comprehensive regulatory framework designed to:
→Prevent insiders from managing companies to their benefit and to the detriment of public investors
→Prevent issuance of securities having inequitable or discriminatory provisions
→Prevent management of investment companies by irresponsible persons
→Prevent the use of unsound or misleading methods of computing earnings and asset value
→Prevent changes in the character of investment companies without investor consent
→Prevent investment companies from engaging in excessive leverage
→Ensure disclosure of full and accurate information about the companies and their sponsors
Investment Advisers Act of 1940
Requires the registration of anyone in the business of offering investment advice — including the adviser to an investment company. The act promulgates disclosure rules with respect to the adviser’s interests in all transactions, contains anti-fraud provisions, and requires that investment guidelines in the client agreement are adhered to. The SEC inspects the operations of the adviser to ascertain compliance. Note: hedge funds are currently not regulated as investment advisers or as mutual funds due to exemptions provided by federal law.
40 Act compliance testing
Investment Company Act tests monitored in the trading workflow
The tests defined by the Act, applicable to the OMS environment, are generally related to six categories — and can be engineered to operate in pre-trade mode or portfolio (holdings) mode.
Example: Section 18 borrowing rule — test structure
Section 18(f) prohibits issuance of “senior securities” unless a fund offsets the obligation. Bank borrowing is allowed provided asset coverage is at minimum 300% of the amount borrowed.
Test Name: “At least 300% asset coverage for borrowing.”
Rule: Net assets (NA) plus borrowing ≥ 300% of borrowing
Therefore: NA ≥ 2× borrowing → borrowing ≤ 50% of NA
Formula: |borrowing at fund level| / NA → exception when 50% of NA is exceeded
Tests can operate in pre-trade mode (calculating the position “bucket” combined with settled portfolio position quantity before order placement) or portfolio mode (evaluated when trades have settled). The application varies with requirements of the adviser and specific fund types, instrument types, and domicile of custodied assets.
Benefits
Robust financial risk and compliance management is good business
Talented and effective leaders who understand the scope of the securities industry manage operations that effectively manage risk and compliance controls. Risk management tools focused on credit exposure, issue and issuer concentration, and firm-wide leverage can save firms from substantial trading losses and inadequately managed client and firm-related risk exposure.
Operational efficiency
Pre-trade and portfolio risk evaluation integrated directly into OMS workflows — enabling traders, compliance, and portfolio management to act with confidence in real time.
Regulatory confidence
Automated testing against SEC, UCITS, and internal guidelines — reducing manual compliance workload and ensuring consistent application of rules across all instruments and fund types.
Centralized data integrity
A single, centralized data process with the capability maturity required for complex risk management — with an issuer schema added to support more robust counterparty and diversification testing.
Comprehensive reporting
Integrated reporting supporting investment management, client, and regulatory inquiry at firm, client, fund, and issuer level — replacing fragmented, manual reporting processes.
Leveraged expertise — common results of a successful implementation
✓Prospectus, SAI, guidelines, foreign entity, and IRS business rules analysis
✓Portfolio management business rules, functional requirements, and workflow analysis
✓Request for proposal, vendor evaluation, and testing scenario analysis
✓System configuration, functional integration, and user acceptance testing
Citations
1. Securities and Exchange Commission, Division of Investment Management website (www.sec.gov). SME, legal & industry interpretations appended.
2. “Protecting Investors: A Half Century of Investment Company Regulation”, United States Securities and Exchange Commission, Division of Investment Management, May 1992.
3. Ibid.
4. Clifford E. Kirsch, Investment Adviser Regulation — Step by Step Guide to Compliance and Law, (New York, Practicing Law Institute, 2006).
5. James M. Storey & James M. Clyde, Mutual Fund Law Handbook (Little Falls, NJ: Glasser LegalWorks, 1998).
6. Alan R. Palmiter, Securities Regulation — Examples and Explanations [Cases], (Aspen, CO: Aspen Publishers, 2002).
7. Ibid, p.5.
Robust risk and compliance management is good business.
OmniVista · Management consultancy · AI & Data Science
Integrating risk and compliance into your OMS platform?
OmniVista provides requirements-driven business analysis, vendor evaluation, and implementation support for complex OMS risk and compliance projects.
