programs. Finally, the book concludes with a discussion of emerging topics and trends in the compliance space.
Compliance has evolved from a rote exercise of strictly following regulatory rules to one of the most prominent, dynamic, and multidisciplinary areas of hedge fund management. A strong compliance program can improve the overall operating efficiency and level of communication throughout a hedge fund. Similarly, hedge fund investors benefit from the additional oversight and transparency that comprehensive compliance programs can provide. Regardless of your role in the hedge fund industry, as compliance continues to evolve, developing a fundamental understanding of core compliance concepts is now an essential requirement for success.
Jason Scharfman
December 2016
CHAPTER 1
Introduction to Hedge Fund Compliance
Nearly every profession, whether it is asset management, healthcare, construction, or scientific research, has some areas that require rules and regulations to be followed. At its most basic level, the term compliance refers to the processes and procedures by which an organization adheres to these guidelines. These guidelines may come from a variety of sources. Traditionally, the government is the primary initiator of compliance rules for different industries, but they may come from other sources as well.
Compliance has become a critically important component of investment management and this is particularly true in the hedge fund space. Key questions this book will seek to answer include:
• What exactly is hedge fund compliance?
• How can hedge funds design and improve their compliance function?
• What constitutes best practice compliance?
• What role do financial regulators play in implementing and monitoring compliance?
• Why should investors care about hedge fund compliance?
• What role can third‐party service providers play in compliance?
• What global compliance trends are emerging in the hedge fund industry?
Within the sphere of alternative investment fund managers, the lack of homogeneity creates a number of unique compliance challenges. Indeed, separate books could be written about the different compliance frameworks required to address the intricacies of different alternative asset classes, such as real estate and private equity.
Hedge funds, too, are unique from a compliance perspective. In particular, they tend to be one of the more complex fund management entities. Why? For starters, let us clarify what the term hedge fund refers to. Hedge fund is a broad umbrella term used to classify many different types of managers that may be organized under differing fund legal structures. The broad nature of the term is one of the reasons that make the category of fund managers known as hedge funds unique and challenging from a compliance perspective. Other key reasons for the increased complexity of hedge fund compliance include:
• Variety of different strategies employed —Hedge funds utilize a number of different investing strategies. Common hedge fund trading strategies include global macro; long‐short equity; market neutral; event‐driven strategies, including merger arbitrage and special situations; convertible arbitrage; sector funds, including healthcare or energy funds; quantitative strategies; and even multistrategy funds. Although other types of alternative investment categories contain distinctions, the variety of investment strategies employed by hedge funds is relatively large in comparison.
• Trading and operating on a global scale —In many cases, hedge funds may conduct not only trading but also fund‐structuring and asset‐raising activities in multiple jurisdictions around the globe. This global landscape contributes to the complexity of the compliance environment surrounding hedge funds.
• Wide range of instrument types traded —To facilitate both the trading activities of a wide number of strategies, as well as the broad investment flexibility within different strategies, hedge funds often trade a wide variety of instruments. These can include equities; swaps; swaptions; forwards; futures; options; various types of bonds, including treasuries, convertible bonds, and catastrophe bonds; bankruptcy claims; syndicated loans, including bank debt, mortgage‐backed securities, private investments in public equity (PIPES), repos, and reverse repos; commercial mortgage‐backed securities (CMBS); and credit default swaps (CDS). The use of different strategies can‐not only subject hedge funds to the oversight of different financial regulators and exchanges but the combined effect of utilizing multiple instruments also increases the complexity of administering compliance across various security types.
• Variety of trading implementation strategies —To implement trading strategies, hedge funds may employ a wide variety of trading procedures. These may include variations on:
i. Who is actually deciding to trade? (i.e., a human being, an automated computer trader, or some combination of the two)
ii. The timing of trades – Are they spaced into the market over time or all at once?
iii. The process of executing trades – Hedge funds may provide instructions to counterparties to execute trades in a number of different ways, including over the telephone or through electronic methods, such as instant message or e‐mail. The reasons for this may depend on a number of factors, including the size of the hedge fund, the sophistication of a hedge fund's trading platform, the markets they trade in, and the way they work with trading counterparties. This variety presents a number of unique compliance challenges.
• Use of multiple prime brokers and other counterparties —Prime brokers are companies that facilitate the implementation of a hedge fund's trading strategy. Companies that provide prime brokerage services are typically referred to as broker‐dealers. In their work with hedge funds, they typically offer hedge funds a number of services, including trade clearing, execution, and leverage financing. Today, it is common for hedge funds to utilize multiple prime brokers.
Hedge funds do this for a variety of reasons, including diversifying their exposure across multiple counterparties as opposed to putting all of their eggs in one basket. The risk in using a single prime broker was highlighted after the 2008 failure of Lehman Brothers. There may also be other types of brokers utilized in addition to prime brokers. One example is brokers known as executing brokers. These brokers typically work directly with prime brokers or, in some instances, directly with the funds, in executing trades. Another type of broker is called a futures commission merchant that facilitates trading in futures.
Hedge funds may also utilize a number of other trading counterparties for securities, such as swaps. These swap counterparties are commonly referred to in the industry as ISDA counterparties. This name comes from the standard master agreement often used to implement these arrangements that is provided by the the International Swaps and Derivatives Association (ISDA).
The use of these multiple prime brokers and counterparties often creates unique needs among hedge funds for specific compliance oversight of the ways in which they interact with these groups.
• Enhanced research techniques– From an investment research perspective, hedge funds traditionally employ a relatively wide array of techniques as compared to other fund managers. These avenues may include research activities, such as discussion with industry experts, and the utilization of expert networks. Expert networks are for‐profit companies
