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Critical Issues for Hedge Funds

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Hedge Funds Not Sold on Self-clearing

June 4, 2007
By John Hintze
Correspondent

Hedge funds have good economic reasons to consider self-clearing of their trades: Operational and technology costs are falling, and they wouldn't have to pay as much in prime-brokerage or clearing fees. They would also have the advantage of control. Yet few hedge funds have taken the leap into self-clearing, still perceiving the hurdles as outweighing the benefits.

Hedge funds are typically run by traders whose goal of maximizing revenues and returns remains first on the priority list. "Fund managers do what they do best, which is the business of generating revenues, rather than becoming a back office," said Gerry Murphy, president of SunGard Data Systems' brokerage and clearing solutions unit, explaining why few hedge funds use his company's Phase 3 platform for self-clearing.

The two other large providers of trade processing software--Broadridge Financial Solutions, which was spun off by Automatic Data Processing this year, and Thomson Financial--also have yet to break out as suppliers to the hedge fund segment. But when the revenue opportunities of recent years moderate, cost-cutting is likely to become a more important part of the profit equation, and self-clearing could be part of the solution.

Citadel Investment Group, the Chicago-based hedge fund giant, has already seen the light, starting a self-clearing broker-dealer in early 2005. "Citadel went to self-clearing for a multitude of reasons, not the least of which was it improved its ability to finance its positions and to borrow stock on better terms," said a source close to the firm. Citadel may be the only hedge fund today that self-clears, running its books and records in-house on software licensed from Shadow Financial of Edison, N.J.

Easier and Inexpensive

Despite the relative scarcity of hedge funds and even broker-dealers choosing to self-clear, it's never been as inexpensive and easy to do from an operations perspective. Chris Petruzzi, who runs San Clemente, Calif.-based brokerage Petruzzi Securities and is a professor of accounting at California State University in Fullerton, opted to self-clear two years ago, after working as a money manager for hedge fund giant Paloma Partners Management Co. of Greenwich, Conn.

Petruzzi estimated hardware costs to self-clear 10 million shares a day--his firm's average--to be less than $30,000, covering two servers and a Cisco Systems firewall. He also spent $30,000 for accounting and legal costs to open the broker-dealer--tasks he completed in-house--and receive self-clearing approval. During the year in which the application to join Depository Trust & Clearing Corp. (DTCC) was in process, Petruzzi also employed a manager who had worked in self-clearing firms, since DTCC likes to see experienced personnel working for new applicants. And Petruzzi developed his own trade-processing software. He said ongoing costs included less than $200 daily to settle 40,000 to 50,000 trades a day at DTCC.

Joe South, president of Shadow Financial, said that $70,000 worth of Intel-based hardware, running ShadoSuite software, can support the primary self-clearing site and the disaster recovery and test sites, and process approximately 250,000 trades a day. He added that a single operations professional could handle all exceptions. "Generally, a firm already has the staff to deal with these issues," South said.