Accurate calculations are critical to strategic decision making, managing collateral, and investor returns—the overall success of hedge funds. Leveraging advanced technology and expertise through outsourced shadow accounting can avoid significant issues and give fund managers the edge they need in competitive conditions.
Outsourcing shadow accounting services to a trusted partner provides many benefits to hedge fund managers, including increased speed and scalability, validating fund administration records, and improving decision-making.
The benefits of outsourcing shadow accounting for hedge funds
Shadow accounting is particularly valuable in today’s complex multi-prime and tri-party environment when managing collateral is more critical than ever. Counterparties demand larger amounts of collateral, and transactions involve more of them. An outsourced shadow-accounting firm’s sophisticated technology and broad knowledge of counterparties can help hedge funds navigate these challenges. When delivering alpha depends on a small number of basis points, handling this complexity most efficiently can have a material impact on the hedge fund’s returns.
In instances when a counterparty makes the calculations, it may be biased and call more than the amount to which it is entitled. Shadow accountants can help hedge funds by confirming that these three types of collateral calculations are executed correctly:
- Initial collateral, also known as initial margin
- Amount paid to the hedge fund when the value of the collateral rises
- Calls paid to counterparties triggered by changes in the collateral’s valuation, also known as variation margin
Ensuring accuracy in collateral and margin calls
Assuring accuracy in margin calls relies on understanding the thresholds for collateral valuation as well as when those thresholds need to be adjusted. Thresholds vary by product and by market, with the tightest thresholds for traditional securities and developed markets, where they can run four to five basis points because bid-ask spreads typically run three to four basis points. For exotic over the counter (OTC) instruments, thresholds can range as wide as 40 to 50 basis points.
When hedge fund managers lack adequate technology and processes, it hampers their ability to check margin call numbers. The technology to value OTC trades daily can become critical to their business. Depending on their size, hedge funds may be limited to data from their own experience, unlike a shadow-accounting firm that typically views similar securities across multiple sets of books.
Overcoming complex counterparty relationships
Familiarity with multiple sets of books across clients helps shadow-accounting firms more easily identify patterns. They can tell if valuations are diverging because of market volatility and know if certain counterparties consistently rely on inaccurate valuations. They also have the perspective to recognize when thresholds are changing.
The sheer number and complexity of counterparties presents a further challenge to hedge funds that check collateral calculations on their own. Whereas a hedge fund might once have dealt with perhaps two or three counterparties, today it may deal with 20 counterparties scattered around the world. As part of risk reduction efforts, hedge funds are also now engaging in more complex transactions than previously. For example, in tri-party agreements, a fund trades with Firm A, has an agreement and places all its initial collateral with Firm B, and then pays variation margin to Firm A. It’s time-consuming for the fund to track all the details involved in such an agreement, but straightforward for an outsourced shadow accounting firm with the latest technology and specialized expertise.
Ready to take the next step?
Using outsourced shadow accounting allows fund managers to focus on what they do best: manage money for a growing book of clients. It spares them the need to develop their in-house systems and related expertise. Instead, they benefit from the outsourced shadow accounting firm’s up-to-date technology and expertise informed by experience across the alternative fund industry.
Find out more about the benefits of outsourcing shadow accounting for fund managers in an increasingly complex investing and operating environment. Download our recent insight report, Enhancing Operational Efficiency: Outsourcing Shadow Accounting.
