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Derivative use forecast to rise

Date: Friday, December 5, 2008
Author: Margie Lindsay, ICFA magazine.com

Use of derivatives by 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 Protiviti, an independent risk consulting company.

The report warns changes need to be made to secure the operating environment for derivatives and ensure that UK companies maintain their competitive advantage.

According to the study, 79% of traditional fund managers, hedge fund managers and service providers expect their company's use of derivatives to increase. Most (84%) also plan to improve derivative capabilities over the coming year.

The overwhelming driver behind companies considering making improvements to derivatives capabilities is demand from the front office and competitive pressures (68%). Ucits approval and the need for daily risk management was the next most popular incentive to invest according to one in ten of those surveyed.

A minority of firms (16%) said they are unlikely to invest in derivatives capabilities. They said cost was a main factor and a view that derivatives will be less of a requirement in future.

Although fund managers and the wider investment community are still using derivatives, almost a third (31%) of those surveyed said 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 were given by 21% of those surveyed. The remainder said it was time constraints on daily processes, inaccurate data and robustness of the control environment.

A failure to provide a secure operating environment for derivatives could lead to a back-log of confirmations and settlements and consequent risk, compliance and fund reporting issues, concluded the study. The result could be clients that fail to award mandates or mandates taken away from fund managers who cannot demonstrate the robustness of their operations and risk management.

"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," said Rob Nieves, director of Protiviti.

The survey also highlighted differences between traditional and hedge fund managers. Hedge funds tended to rate their current capabilities lower than traditional fund managers. Protiviti suggested some traditional fund managers may be under estimating the work required to manage the derivatives lifecycle competently.