In my 22+ years working in investment compliance, a question I get frequently is whether investment compliance (or portfolio compliance) is considered front office or back office. My answer is always, “it depends.”
While it’s tempting to say that compliance in general is a review of “after-the-fact” activities (think of other industries like Healthcare Compliance and Food Manufacturing Compliance, Aerospace Compliance), Investment Compliance is one of the areas where compliance should be checked before activities are taken. The risks are just too great to wait until after a trade is executed to find out that the order was not compliant in the first place.
But many compliance departments really lack the proper number of resources to staff an analyst during all trading hours. If the asset manager is global, they would need to staff analysts during Europe, Middle East and Africa (EMEA), North America (NA) and Asia Pacific (APAC) trading hours. They would have to account for holidays, vacations and other short-term gaps like maternity/paternity leaves and disability leaves. This is not how compliance departments are often staffed, either in the Financial Services sector or others. Compliance in the general sense is a forensic testing of people, processes, and technology to ensure that activities that have already occurred are in compliance and whether or not there is an indication of intentional wrongdoing.
But if this were the case in Investment Compliance, by the time a violation was detected, the financial losses could be great. Also, the Securities Exchange Commission (SEC) charges US asset managers to diligently “prevent and detect” trade violations. So, trade orders really need to be checked for compliance before execution (so-called “pre-trade compliance”), but who is responsible for this check?
In my experience, about 30% of US asset managers are defining pre-trade compliance as a front office responsibility. This means that while pre-trade checks are occurring, the front office has a right and responsibility to review the results of the pre-trade checks and give explanations if they proceed with an order despite the apparent lack of compliance. This activity is then reviewed by Investment Compliance, after-the-fact, and anomalies investigated.
The more traditional operating model would be for investment compliance to review all of the pre-trade checks before allowing an order to proceed to the trading desks. However, as we’ve discussed earlier, this is a difficult staffing model for a department whose mandate looks more like a back-office oversight role rather than an operational role.
Lately, we’ve begun to notice a new trend, such as departments being created to manage the pre-trade checks that are more operational in nature. These departments are used to staffing analysts during the trading hours (think middle office departments like Operations, Data, Risk, etc.). Front office personnel are often already comfortable working with these operational departments, however, a word of caution if your organization is considering this model.
Operational departments usually report to a Chief Operating Officer (COO), and their main stakeholder is generally the front office, meaning that they might be tempted to clear pre-trade checks for the front office without enough “arms-length” distance to provide proper scrutiny.
In my opinion, the best model is advocating that the front office is ultimately responsible (the “front line”) for managing their customer’s money in compliance with the customer’s mandates. The pre-trade checks should be designed to support the front office in their activities, and post-trade compliance should be managed by Investment Compliance, after-the-fact, to provide the proper amount of oversight that a second pair of eyes only can.
There are also hybrid options. The front office could be given full reign over rules that are not regulatory. This is often best when the Portfolio Managers are closer to their customers’ wishes than Compliance is, and therefore more capable of making a decision on clearing a pre-trade violation.
In the end, whether you call your team part of the front office or the back office, your organization will be compliant with the SEC as long as you have a system of checks to “prevent and detect” violations, a certain amount of oversight, and a consistent process of investigating anomalies. If you’d like to talk to us about your operating model, feel free to reach out to me via email at joylangdon@tilliestar.com or 774-218-5092.
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