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Fund management firms maintain appetite for derivatives, says report

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Use of derivatives by UK fund managers will rise over the next 12 to 18 months despite market turbulence and record levels of redemptions from hedge funds, according to a report from indep

Use of derivatives by UK fund managers will rise over the next 12 to 18 months despite market turbulence and record levels of redemptions from hedge funds, according to a report from independent risk consulting company Protiviti.

However, the report warns that changes need to be made to secure the operating environment for derivatives and ensure that firms maintain their competitive advantage.

According to Protiviti, 79 per cent of traditional fund managers, hedge fund managers and service providers expect their firm’s use of derivatives to increase, and 84 per cent plan to improve their derivative capabilities over the coming year.

The overwhelming driver behind companies considering making improvements to their derivatives capabilities is demand from the front office and competitive pressures, cited by 68 per cent, while Ucits approval and the need for daily risk management was the next most popular incentive, mentioned by one in ten of those surveyed.

A minority of firms (16 per cent) say they are unlikely to invest in their derivatives capabilities because of cost and a belief that derivatives will be less of a requirement for their firm in the future.

Almost a third (31 per cent) of those surveyed say that a lack of available skills and resources was the most significant risk they faced in managing derivatives in the future. Governance arrangements and the segregation of duties was cited as a risk by 21 per cent, while others mentioned time constraints on daily processes, inaccurate data and the robustness of the control environment.

According to Protiviti, a failure to provide a secure operating environment for derivatives could lead to a backlog of confirmations and settlements, and consequent risk, compliance and fund reporting issues.

The end result could be that clients would fail to award mandates or take them away from fund managers who cannot demonstrate the robustness of their operations and risk management.

‘We believe that the fund management industry has reached an inflection point in its use of derivatives and that they are here to stay as an asset class,’ says Protiviti director Rob Nieves. ‘While firms would like to improve their derivative capabilities, many are caught in a vicious cycle of being unable to free up skilled staff who could tackle more strategic issues such as implementing new systems and getting better value from their outsourcing providers.

‘For the UK to maintain its competitiveness in the fund management sector, we believe companies will need to invest in systems, data and people to improve efficiency and the future success of derivatives for individual fund managers.

‘Investors are increasingly sophisticated and understand that market turmoil was more the result of poor lending practices and dubious debt securitisation arrangements than of questionable derivatives transactions. In many cases, it would appear that derivatives strategies have helped firms remove at least some downside risk, and our survey suggests that derivatives will play an increasingly important role in fund management going forward.

‘Our survey also highlights differences between traditional and hedge fund managers, with hedge funds tending to rate their current capabilities lower than traditional fund managers. While further research is needed, our experience suggests that some traditional fund managers may be underestimating the work required to manage the derivatives lifecycle competently.’

Protiviti, a wholly-owned subsidiary of recruitment firm Robert Half International, is a consulting and internal audit firm composed of experts specialising in risk and advisory services, and was launched in 2002 with the recruitment of 760 professionals from Arthur Andersen’s US internal audit and business risk consulting practices.

The firm now has more than 3,000 professionals who provide clients with assistance in areas such as finance, operations, technology, litigation and governance, risk and compliance from more than 60 offices in the Americas, the Asia-Pacific region, Europe and the Middle East.

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