How should CCOs deal with alternative data risks

From insider trading to privacy concerns, CCOs look to manage data sources

Hedge fund CCOs are being urged to monitor the compliance risks from alternative data sources more closely as technology fuels their growth.

In March, a poll from sister title HFMWeek readers, one-third said they are actively harnessing alternative date techniques as part of their investment analysis. In contrast, 40% of managers say they are not utilising any such offerings, while nearly a quarter are experimenting with some of these methods but have yet to make them a central part of their investment offering.

Alternative data is best defined as non-traditional research that is not price or volume related but helps predict inputs and outputs better.

That could be using technology to measure sentiment on social media, satellite and drone imagery, transactional data for credit cards, mobile phone data and other areas.

Some hedge funds have built their business around new technologies and research techniques. One hedge fund spent years developing technology to track weather patterns affecting crop growth in order to more effectively invest in commodities, for example.

Managers are also purchasing significant amounts of data from third-party providers and there have been a proliferation of firms offering services in recent years.

In a HFMCompliance survey of hedge fund CCOs last month, four in 10 said they have used a third-party alternative data research provider.

“Alternative data providers are currently experiencing a flood of interest in their offerings,” said Doug Dannemiller, investment research leader for the Deloitte Center for Financial Services, who recently authored a research paper on alternative data.

“That approach is the fastest way to gain capabilities. Just a year ago, these vendors were struggling to gain traction.”

Researchers Opimas say asset managers are spending 21% more every year in alternative data and buy-side and sell-side spending will increase from just over $4bn in 2017 to more than $7bn a year by 2020.

In a recent Deloitte paper, Worldwide IT Spending 2015-2020, published in May, the firm said hedge fund spending on alpha generation data sources to double annually between 2015 and 2020.

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Compliance risks

The growth has led to questions from investors looking to monitor compliance risks at managers. One major hedge fund investor has created a new questionnaire this year to examine how managers monitor risks arising from alternative data.

Experts say that much of the legal and compliance landscape surrounding alternative data is undefined as policymakers get to grips with how to handle big data.

However, lawyers say there are some core areas that every CCO should consider before using alternative data sources and providers.

They include insider trading risks, breach of contract, privacy, piracy and website terms of use for data scraping, piracy and copyright.

“Clients need to be careful that the data they are buying is data they are allowed to have,” says Peter Greene, partner at Lowenstein Sandler. “That means the original user has given authority to be used whether credit card date or even satellite imagery.”

Insider trading risk is the top concern for hedge funds as it can be a criminal offence as well as being a top regulatory priority for the SEC.

“There is a lot of undefined space with alternative data, but venturing into material non-public information is a main concern,” says Dannemilller.

Emmett Kilduff, founder of alternative data provider EagleAlpha, says the other main questions from managers surround the origins of data, privacy policies and the exclusivity of data.

He says there are still few legal guidelines around these areas and policies differ from jurisdiction to jurisdiction.

“The market will welcome questions on all these topics from regulators,” says Kilduff. “There is a big hole at the moment in all markets.”

The US and Europe differ considerably on insider trading rules. The US has a narrow definition of insider trading law where information can be both material and non-public but still might be allowed as long as information has not been misappropriated and no duty has been breached

Under the EU’s market abuse regulation (MAR) that came into force in July 2016, European rules mean the use of any price sensitive or material non-public information is banned and historically the region has taken a tougher stance.

For example, Greenlight Capital was fined nearly $10m by the UK’s FCA in 2012 when it breached UK rules while believing it was in line with US standards. Lawyers say it is harder to buy alternative data in the UK and Europe while some say exclusive data sets are effectively banned.

However, the US has also been tough on prosecuting insider trading cases and pursuing regulatory enforcement in recent years too.

Lawyers say the treatment of alternative data could follow a similar pattern to the regulatory scrutiny of expert networks.

Expert networks provide research to hedge funds often using former employees or close associates of affected firms.

The SEC launched a sweeping probe of the networks to investigate if they breached insider trading rules by releasing price sensitive information that was not publicly available.

The probe led to a revolution in expert networks causing hedge funds to rethink how they used them as well as networks tightening their compliance standards.

“If you compare it to expert networks many years ago then some were not as tight with their compliance procedures as they are now,” said Greene.

“Alternative data is somewhat comparable to where expert network providers were several years ago. When you meet data providers today then some of them understand the importance of compliance procedures but not all of them.

“It is very important for legal and compliance to meet with, and certainly talk with, the data provider to ensure the providers understand the issues and their importance. Without that, I would feel very uncomfortable moving forward to contract negotiations and a trial stage.”

CCOs, compliance professionals and lawyers say that alternative data is not currently on the radar of the SEC but that could change quickly.

“We have not seen the SEC take a hard look at it but ultimately regulators are going to want to understand this area and how data is procured,” says Greene. “What are you buying? How did you get it? What are you doing with it? Sophisticated managers are not buying anything without looking at it very carefully.”

Another example highlighted by Deloitte is scrutiny of the credit scoring process by banks and lending companies using alternative data sources to supplement their ratings.

The Consumer Financial Protection Bureau is interested in both the new data sources and the new methods being considered for supplementing the credit analysis process. The bureau’s concerns range from privacy rights and transparency to discriminatory outcomes based on characteristics or behaviours.

“While investment management is significantly different than consumer lending, an important lesson for investment management firms to consider is that regulators are taking note of alternative data,” the Deloitte paper states.

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Best practice

Greene recommends that all CCOs interview the data providers they are using to ensure they have a full grip on compliance procedures.

HFMCompliance polling shows 80% of hedge fund CCOs have been given a veto over all alternative data purchases at hedge funds while 20% will refer decision depending on the nature of the research. No managers have a laissez-faire approach not involving compliance.

In addition, four in 10 CCOs say they have turned down research over compliance concerns while a further 40% say they have asked for clarifications. Just 20% say they have always been comfortable with the research they have received from providers.

One COO at a sub-$1bn fund in London says the compliance risks are too great to allow his portfolio manager to use such data sources.

“I can imagine it would breach all manners of privacy laws and data protection regulations,” he says.

As well as an interview, lawyers recommend writing a sophisticated and tight contract ensuring there is no MNPI or other compliance concerns.

“Contracts are important and you need to make sure they have the right to sell the data and they are not breaching any covenant and obligation including the original sources, how it was obtained and anyone else in the chain.”

One general counsel at a $2bn US hedge fund says he always interviews new providers as well as inserting a covenant that there is no MNPI.

“For any new research or data provider, I conduct due diligence on the firm (including speaking to their compliance department if they have one), and insert a covenant in our agreement providing that they won’t provide us with MNPI or any information in breach of a duty to any third party,” he says.

“We also make them acknowledge that we are an investment firm that may trade on the basis of data provided and that we don’t wish to receive any MNPI or information provided in breach of a duty to any party. For an alternative data provider, I would also review any data being sent to our analysts before the analysts receive the data.”

Igor Gonta, CEO of MarketProphit, a data provider, says there is difference between large and small funds in how seriously they take compliance checks.

“Larger funds are definitely very serious about their compliance,” he says. “They will have in-depth discussions to understand how it is being collected, where it is coming from and ensuring it is anonymised.

“Beyond that then firms will protect themselves from licensing agreements. They will put the warranties on data providers to enshrine everything they protect.”

Gonta say agreements are not standardised because it is a new area and the data is very different from source to source, for instance drone imagery to social media tracking.

Deloitte suggests hedge funds firms should consider modifying investor disclosures about investment policy and processes when using alternative data.

In addition, vendors are starting to offer compliance software and procedure recommendations to support investment managers in determining that their alternative data use is regulatory-ready.

Alternative data is an exciting new area that could supplement hedge fund research but there are also lots of uncertainties and CCOs must manage existing and future risks.