Complex Trading Strategies

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Complex Trading Strategies

• Panel Discussion February 18, 2008

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Todays Speakers

• Moderator
• Kevin OConnell, Partner, PricewaterhouseCoopers
  LLP
• Panelists
• Gillian Christie, Director, Deloitte Consulting
• Don Gignac, Senior Managing Director,
  International Fund Services
• David Lang, Managing Director, Goldman Sachs
  Co.
• Michael Rosenberg, Director, Citi

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Setting the Stage..

• 4 significant trends related to complex trading
  strategies have emerged recently in the asset
  management industry
• Continued evolution and innovation in investment
  products.
• Need for high quality resources and robust middle
  and back office support.
• Significant competition for high quality staff.
• Consideration of functions to outsource to allow
  the asset manager to focus on core competencies.

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Todays Agenda

• Product evolution and innovation
• Long/Short Funds
• Short Selling
• Alternative Funds
• Complex securities (focused on derivatives)
• Understand the types of derivative products
• Identify the operational and technology
  challenges
• Manage successful relationships with your service
  providers and
• Provide an overview of vendors who provide post
  trade support.
• Questions Answers

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Long/Short FundsRoles and Responsibilities in a
Tri-Party Relationship

• Three Parties
• Custodian
• Holds cash and securities
• Segregated account containing collateral pledged
  to the PB to off set short exposure.
• Prime Broker
• Secure locates
• Reflect Short Position
• Fund (Client)
• Can interface with both custodian and PB.
• Provided with consolidated reporting on all
  positions and cash.

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Long/Short Funds (continued)130 / 30 Strategy
Implementation when a Tri-Party Agreement is
employed
Mutual Fund
30 mm Short Eq (Short proceeds have been wired to
Custodian Acct)
Short Sale Activity 30 mm
130 mm Long Eq
Long Trades 130 mm
Mutual Fund Custodian Acct Pledged
Margin Calls
PB
Pledge Feed
DTC Confirm
DTC Confirm
Sell Shorts Buy to Covers
Buy Longs Sell Longs
Executing Broker
Scenario (100 physical equities)
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Short SellingLife Cycle of a Short Sale

• Pre Trade Expressing a negative view and
  realizing the economics.
• Secure a Locate for the Desired Short position
• FTP, telephone, email, Bloomberg
• Dividend liability - Typically 100 of gross
  dividend
• Execution
• Execute the Trade (Identify Executing brokers,
  set up accounts DVP/RVP, documentation with fund
  PB EB.
• Long positions Buy Long or Sell Long
• Short positions Sell Short or Buy to Cover

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Short Selling Life Cycle of a Short Sale
(continued)

• Post Trade
• Client communicates trading activity to Custodian
• Communicate short trading activity to Prime
  Broker (Swift, CSV, PB Web, FTP)
• Settlement Trade matching and affirmation, fail
  management.
• Monitoring the Short Position
• Reporting Prime Broker will provide Custodian
  with a short position report so a daily,
  aggregated position report can be produced by
  Custodian
• Short position gets marked to market daily
• Daily Short Rebate Report or Stock Loan Billing
  Report

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Short SellingLife Cycle of a Short Sale
(continued)

• Post Trade
• Margin Requirements for Reg T 150 on short
  positions
• Initial Margin vs. Maintenance Margin
• Short Sale Proceeds 100
• Margin (cash or securities) 50
• Margin requirements are calculated on Trade Date,
  but must be satisfied by Settlement Date (TD3
  for regular way US equity settlement under
  Regulation T)
• Enhanced Leverage Greater leverage and enables
  fund to extract short sale proceeds to purchase
  longs.
• Short Rebate Overnight Yield (Opening Fed
  Funds) Stock Loan Fee
• Rebate is an annualized number that accrues daily
  and is realized monthly
• Short Sale Proceeds will be segregated to serve
  as collateral for the short position
• Negative Rebate exists when the stock loan fee
  exceeds the overnight yield
• The short rebate accrual can change daily based
  on change in the stock loan fee, the overnight
  yield (FF) or a change in the market value of the
  short position.

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Alternative Investment Products

• Hedge Funds
• Lightly regulated, private investment vehicle
• Structure can vary depending on organizational
  jurisdiction
• Types include LP, LLC, Company, Trust
• Sources of Capital
• Sophisticated investors (e.g., institutions,
  endowments, high net worth individuals)
• Appeal
• Performance
• Diversification

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Alternative Investment Products
(continued)Comparison of Hedge Funds to Mutual
Funds
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Alternative Investment Products (continued)
Hedge Fund Investment Tools and Techniques

• Short Selling
• Selling shares without owning them and buy them
  back at a lower price
• Arbitrage
• Exploiting price differentials that exist as a
  result of market inefficiencies
• Leverage
• Investing borrowed money to increase exposure to
  an investment
• Short selling, reverse repurchase agreements,
  loans, derivatives, etc.
• Derivatives
• Contracts whose values are based on the
  performance of any underlying financial asset,
  index or other investment
• Futures, swaps, options, swaptions, forward
  contracts, etc
• Investing in anticipation of a specific event or
  in deeply discounted or distressed securities
• Merger, takeover, spin-off, bankruptcy
  proceedings, etc

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Alternative Investment Products
(continued)Private Equity Partnerships (PEPs)

• Structured as private investment partnerships in
  which only qualified investors may participate
• Typically charge a management fee (1.5 to 2.5)
  and incentive fee
• Sources of capital
• Sophisticated investors (Institutions,
  endowments, high net worth individuals)
• Ultimately liquidated

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Alternative Investment Products
(continued)Investor Considerations

• Investor Capital
• Investors make a capital commitment (pledge to
  invest)
• Fund makes capital calls to summon cash to pay
  for expenses or purchase investments
• Lock-up/Liquidity Restrictions
• Redemption not allowed
• Lock-up period often 5-10 years
• Some exit options prior to fund liquidation
• Management can agree to a transfer of an
  investors interest to another suitable investor
• Management company might assume the investors
  interest
• Investors interest might be allocated over the
  remaining partners

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Alternative Investment Products
(continued)Private Equity Holdings / Strategies

• Holdings
• Direct investment (DI)
• Invest directly in a company (not yet public)
• Partnership investment (PI)
• A capital commitment to another P.E. partnership
• Investments generally illiquid
• Profit results from sale, merger, IPO, etc. of
  underlying companies
• Strategies
• Venture capital
• Leveraged buyout
• Mezzanine financing (debt before going public)
• Distressed debt
• Real estate
• Development capital

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Complex SecuritiesTypes of Derivative Products
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Complex Securities (continued)Market Trends -
Volumes
Source ISDA, ABN AMRO Research,

• OTC Derivatives markets have witnessed phenomenal
  growth in the recent years in terms of volume of
  transactions, universe of products traded and
  breadth of counterparties

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Complex Securities (continued)Derivatives
Operations Survey Processing and Automation
Trends
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Complex Securities (continued)New Instrument
Committee

• Define what constitutes a new product
• Identify key areas for consideration
• Formalize review process
• Additional recommendations

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Complex Securities (continued)Derivatives
Processing Lifecycle
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Complex Securities (continued)Challenges Faced
by Industry Players Trading and Processing
Derivatives
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Complex Securities (continued)Interacting with
your Prime Broker

• Trade reporting EOD Post execution record of
  all short trading activity
• Reporting includes Cash Balances, Activity,
  Positions, Financing Accruals
• Reporting provided via web portal or data
  extracts to the asset owner, fund manager, and
  administrator
• Trade matching and settlement with executing
  brokers
• Asset Servicing Corporate Actions Dividend
  Processing
• Additional Services Risk Reporting, Performance
  Attribution Reporting, Cap Intro, Business
  Consulting Services

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Complex Securities (continued)Margin
Collateral Management

• Margin Fund can post long positions or cash to
  meet margin calls.
• 130/30 Example Short position at PB will attract
  a 150 margin Requirement
• 30 dollars in SMV will require 45 dollars in
  cash or 90 dollars in fully paid for long
  position. Note Regulation T applies a 50
  haircut on fully paid for long
• Custodian will identify 90 dollars worth of long
  assets that are pledged to prime broker to
  satisfy margin requirements.
• Electronic feed to PB identifies securities
  pledged and allows the PB to accurately calculate
  and apply the necessary margin.

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Complex Securities (continued)Vendor Landscape
Post Trade Services
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Complex Securities (continued)Barriers to
Electronification
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Electronic PlatformsNear Future Trends
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In Conclusion..

• From the UK Financial Services Authority, 2008
  Financial Risk Outlook
• Managers need to ensure they are retaining or
  employing staff of sufficient experience and
  expertise to understand and manage the
  increasingly complex range of products that are
  entering the market.
• They also need to implement effective systems and
  controls to monitor and control the risks
  associated with these products before the
  products are launched, as well as maintaining
  them on an ongoing basis

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Vendor Analysis - SwapsWire
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Vendor AnalysisDepository Trust Clearing
Corporation
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Vendor Analysis - Thunderhead
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Vendor Analysis Scrittura (Interwoven)
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Vendor Analysis - Markit