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1.1.2010 Ops Risk

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  • 1. Operations Risk Assessment Program For Hedge Fund Managers January 2010 Developed by Scott Lane HEDGE FUND OPERATIONS RISK - 1 CONFIDENTIAL
  • 2. Contents • Background • The Opportunity • Risk Paradigm • Institutional Paradigm • A New and Comprehensive Approach • Examples HEDGE FUND OPERATIONS RISK - 2 CONFIDENTIAL
  • 3. Background • Basel II Definition for Operational Risk for Financial Institutions: “…the risk of loss resulting from inadequate or failed internal processes, people and systems…” • While Basel II applies to financial institutions, the principles can be applied to any financial services firm, including hedge fund managers • Take Away from Basel II: Paradigm that Focuses on Processes, People, and Systems and Infrastructure Operational Risk Systems and Processes People Infrastructure HEDGE FUND OPERATIONS RISK - 3 CONFIDENTIAL
  • 4. Background (continued) • Institutional investors continue to demand ever more formalization and sophistication for operations risk management by hedge fund managers • The Great Recession we are beginning to exit will only increase the importance of and scrutiny on operations risk • Much more U.S. and European regulation of hedge funds expected • Increased focus on risk management expected • Fund managers will increasingly need to demonstrate that they are adequately managing their operational risks to retain and attract capital • Consequently there is an opportunity to develop an integrated operations risk program that: • Incorporates risk management principles and looks and feels like an institutional program • Is a consistent approach to applying judgment, resulting in increased comparability of fund managers • Not only assesses control design but also assesses and tests operating effectiveness HEDGE FUND OPERATIONS RISK - 4 CONFIDENTIAL
  • 5. The Opportunity Hedge Fund Practices Risk Institutional Paradigm Practices Develop Integrated Operations Risk Approach Increased Need for Regulation Comparability HEDGE FUND OPERATIONS RISK - 5 CONFIDENTIAL
  • 6. Risk Paradigm Operations Risk Level Resources: Mix of people, processes, and systems are the hedge for operations risk Risk Reduction Resources Allocated to Mitigate Operations Risk Equilibrium where cost of control measures balances operations risk Question 1: is the operations risk adequately reduced / managed? Question 2: has the optimal mix of people, processes, and systems been applied to manage operations risk? HEDGE FUND OPERATIONS RISK - 6 CONFIDENTIAL
  • 7. Risk Paradigm (continued) Low High Automation Automation Systems • Non-routine transactions • Routine transactions • Illiquid positions • Highly liquid Positions • High judgment required • Low judgment required • Example strategy: • Example strategy: Long-Short distressed Market-Neutral Equity • Automate to extent • Automate everything possible but limited HEDGE FUND OPERATIONS RISK - 7 CONFIDENTIAL
  • 8. Risk Paradigm (continued) High Skills / Lower Skills / Experience of Experience of Operations Team Operations Team People • Non-routine transactions • Routine transactions • Illiquid positions • Highly liquid positions • High judgment required • Low judgment required • Example strategy: distressed • Example strategy: Long- Short Market-Neutral Equity • Hire seasoned and skilled professionals at all levels • Hire seasoned at top levels, less experienced and skilled at lower levels HEDGE FUND OPERATIONS RISK - 8 CONFIDENTIAL
  • 9. Risk Paradigm (continued) Processes • The mix of systems and people necessary to optimize control depends on the situation / investment strategy • Key processes should be formalized, well documented, and communicated regardless of the situation • The only question is whether those processes are executed and monitored by people or systems HEDGE FUND OPERATIONS RISK - 9 CONFIDENTIAL
  • 10. Risk Paradigm (continued) • Borrowing from how credit risk is assessed, each operational area / operations risk driver can be assessed for the frequency of failure and the impact stemming from failure • These assessments can then be aggregated to build a heat map of the entire operations of a firm Example Only Once a Transaction Week Processing Frequency / Probability Once a Level 1 Level 2 Month Valuation Valuation Once a Level 3 Quarter Valuation Once a Compliance Year Once a Natural Decade Disaster $10,000 $100,000 $1,000,000 $10,000,000 > $10,000,000 Impact / Severity HEDGE FUND OPERATIONS RISK - 10 CONFIDENTIAL
  • 11. Institutional Paradigm – Sarbanes Oxley • Sarbanes-Oxley 404 has been executed by the PCAOB who issued the following guidance • PCAOB Auditing Standard No. 5, An Integrated Audit of Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements • Top Down Approach to Scoping: • Identify entity level controls • Control environment • Routine vs. non-routine • Identify significant accounts / risk areas • Control Testing and Assessment • Design effectiveness • Operating effectiveness • Walkthroughs • Key take away: apply a top down approach to identifying risk areas then assess both control design and operating effectiveness, not just design HEDGE FUND OPERATIONS RISK - 11 CONFIDENTIAL
  • 12. A New and Comprehensive Approach Standardized Operational Footprint for Comparability Operational Area Operational Area Operational Area A B C People Risk Test and Paradigm of Processes Assess Using People, Institutional Processes, & Methods Systems Systems & Infrastructure HEDGE FUND OPERATIONS RISK - 12 CONFIDENTIAL
  • 13. A New and Comprehensive Approach (continued) 1. Define operational areas common across fund managers 2. Perform a risk assessment for each operational area, summarized via a heat map, to determine relative and absolute risk while considering the following for each area: a) Probability or likelihood that an operational breakdown could occur (probability of error) b) Impact or consequences if that area were to breakdown (severity) 3. Assess operational control design across operational areas considering controls composed of: a) People b) Processes c) Systems and Infrastructure 4. Perform walkthroughs for moderate and high risk areas to ensure controls are operating as designed 5. Score each area and document work performed, conclusions reached 6. Apply this framework consistently to allow for comparability of fund managers HEDGE FUND OPERATIONS RISK - 13 CONFIDENTIAL
  • 14. Example – Operational Heat Map • Whether outsourced or not, the operational areas (blue boxes) should be common operational areas across hedge funds • Sub-areas would presumably be fairly consistent as well but would likely vary to some extent Example Only Fund and Marketing & Portfolio Legal & Human Information Investor Trading Settlement Investor Risk Mgmt Office Mgmt Fundraising Mgmt Compliance Resources Technology Relations Accounting Performance Trade Cash Levels 1 and 2 Regulatory Records Investor Deal Sourcing Liquidity Risk Hiring Process User Support Presentations Execution Movement Valuation Compliance Management Reporting Due Diligence Portfolio Underwriting & Credit & Investor Facilitation - Trade Level 3 Management Performance Systems Vendor Initial Cash Custody Counterparty Liquidity Prospective Allocation Valuation & Trading Measurement Maintenance Management Investing Risk Monitoring Investors Support Entity and Investment Fund Ad Hoc Terms & Position Alliance Systems Travel Tracking & Accounting & Market Risk Firing Process Marketing Structuring Custody Formation and Development Management Monitoring NAV Analysis Governance Due Diligence Subscription / Business Investor Managerial Administrator Management Disaster Accounts Facilitation - AML Process / Partners & Accounting & Reporting & Mgmt Company Recovery Payable Existing KYC Alliances Allocations Analysis Investors Business External Facilities Mgmt Continuity Auditor Mgmt Management Planning Green = low risk Yellow = moderate risk HEDGE FUND OPERATIONS RISK - 14 Pink = high risk CONFIDENTIAL
  • 15. Example – Risk Weighting • There are many ways in which one could rate operational areas and controls • However, the key is to (a) have a consistent approach, (b) apply a risk weighting to the assessment, and (c) actually test the control design via walkthroughs to ensure the ratings assigned are indeed valid Example Only Risk Risk Mitigation Liklihood of Severity from Gross Risk Risk Operational Area Failure Failure Score Weighting People Processes Systems Total Marketing & Fundraising 2.00 4.00 8.00 8.3% 5.00 1.00 1.00 7.00 Portfolio Mgmt 3.00 5.00 15.00 15.6% 4.00 1.00 1.00 6.00 Trading 3.00 3.00 9.00 9.4% 3.00 2.00 4.00 9.00 Settlement 2.00 3.00 6.00 6.3% 4.00 2.00 4.00 10.00 Fund and Investor Accounting 3.00 4.00 12.00 12.5% 4.00 3.00 4.00 11.00 Risk Mgmt 3.00 5.00 15.00 15.6% 3.00 1.00 2.00 6.00 Legal & Compliance 2.00 4.50 9.00 9.4% 5.00 5.00 1.00 11.00 Human Resources 2.00 4.00 8.00 8.3% 2.00 1.00 2.00 5.00 Information Technology 2.00 3.00 6.00 6.3% 5.00 2.00 3.00 10.00 Office Mgmt 2.00 1.00 2.00 2.1% 3.00 2.00 1.00 6.00 Investor Relations 2.00 3.00 6.00 6.3% 4.00 1.00 1.00 6.00 Total Operations 96.00 100.0% 3.80 1.86 2.21 7.88 Liklihood of Failure People, Processes, Systems Once a week 5.00 Excellent 5.00 Once a month 4.00 Very good 4.00 Once a quarter 3.00 Good 3.00 Once a year 2.00 Fair 2.00 Once a decade 1.00 Poor 1.00 Severity from Failure > $ 10,000,000 5.00 $ 10,000,000 4.00 $ 1,000,000 3.00 $ 100,000 2.00 HEDGE FUND OPERATIONS RISK - 15 $ 10,000 1.00 CONFIDENTIAL
  • 16. Example – Supporting Work Example Only SECTION: FUND AND INVESTOR ACCOUNTING People Process System Valuation: Rating Rating Rating Is there a formal valuation committee? (scale of 1 (scale of 1 (scale of Who is on the valuation committee, is the ultimate decision making independent from portfolio to 5) to 5) 1 to 5) management function? Are there minutes taken at the valuation committee? Is there a documented valuation policy? What is the most recent valuation level composition? 4 3 4 How is level 1 pricing determined and supported? How is level 2 pricing determined and supported? How is level 3 pricing determined and supported? Have the external auditors provided any management letter comments on the valuation process? Have the external auditors noted an significant deficiencies or material weaknesses in the valuation area? How often are marks updated? Who is responsible for determining the marks and what are their qualifications? Who is responsible for supporting the marks and what are their qualifications? Approximately how many hours per month / year does operations spend on supporting valuation? What systems are used in the valuation process and how automated is the process? How may prices per position are usually obtained? When was the most recent price override by operations (that being operations overriding portfolio management)? Are any third party experts used in the valuation process? If so how close have their results been to management’s? Have there been any NAV restatements due to valuation? Have there been any significant estimate to actual variances due to valuation? Summary of Analysis Conducted and Conclusions Reached [insert text] Has the Control Design Been Tested (i.e., walkthrough) and are the Controls Operating as Designed? [insert text] List of Attachments and Supporting Schedules [insert text] HEDGE FUND OPERATIONS RISK - 16 CONFIDENTIAL
  • 17. Example – Comparing Fund Managers • Once a standardized approach is applied, fund manages can be more easily compared • The below example compares fund managers who aren’t even in the same investment strategy • One has a focus on people (distressed) while the other has a focus on systems (LSMN) to manage their risk as would be expected • Ultimately they have similar total scores but they take a different path to get there Example Only DISTRESSED EXAMPLE LONG-SHORT MARKET-NEUTRAL EQUITY EXAMPLE Risk Mitigation Risk Mitigation Operational Area People Processes Systems Total Operational Area People Processes Systems Total Marketing & Fundraising 5.00 1.00 1.00 7.00 Marketing & Fundraising 4.00 1.00 2.00 7.00 Portfolio Mgmt 4.00 2.00 1.00 7.00 Portfolio Mgmt 4.00 1.00 5.00 10.00 Trading 3.00 2.00 4.00 9.00 Trading 2.00 2.00 5.00 9.00 Settlement 4.00 2.00 4.00 10.00 Settlement 2.00 2.00 5.00 9.00 Fund and Investor Accounting 4.00 3.00 4.00 11.00 Fund and Investor Accounting 2.00 3.00 4.00 9.00 Risk Mgmt 3.00 1.00 2.00 6.00 Risk Mgmt 4.00 1.00 4.00 9.00 Legal & Compliance 5.00 5.00 1.00 11.00 Legal & Compliance 2.00 3.00 3.00 8.00 Human Resources 2.00 2.00 2.00 6.00 Human Resources 2.00 1.00 3.00 6.00 Information Technology 5.00 2.00 3.00 10.00 Information Technology 3.00 2.00 4.00 9.00 Office Mgmt 3.00 2.00 1.00 6.00 Office Mgmt 1.00 2.00 2.00 5.00 Investor Relations 4.00 2.00 1.00 7.00 Investor Relations 3.00 1.00 2.00 6.00 Total Operations 3.80 2.17 2.21 8.18 Total Operations 2.90 1.68 3.80 8.38 Difference 0.91 0.49 (1.59) (0.20) HEDGE FUND OPERATIONS RISK - 17 CONFIDENTIAL

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