Buy Side Catches Up to Op Risk, and Vice Versa.(operational risk )

On the sell side, experienced in handling market risk and getting ever-more effective at managing credit risk, operational risk was tacked on without too much fuss. Brokerages have been buying systems, establishing processes, building disaster recovery sites and making backup plans for years now.

The buy side was less prepared for operational risk and only recently began in earnest to buy the systems and put the processes in place. Why now? After market scandals and hedge fund collapsesNnot to mention the Sarbanes-Oxley Act and other regulations, business-continuity concerns and security worriesNbig clients are demanding it.

To attract and win business from institutional investors, hedge funds and other asset management firms are finding that they have to show how well they can handle all types of riskNand operational concerns have come to the fore. Legal, compliance and operational risk managementNthree categories often lumped together as organizations come to grips with this newly prominent set of vulnerabilitiesNOmust be more vigilant than ever to protect institutionsO reputations as well as profits,O Deutsche Bank general counsel Richard Walker, a former director of the Securities and Exchange CommissionOs enforcement division, said at the Securities Industry AssociationOs Risk Management Conference in New York in June.

A case in point is pension funds, which in looking for absolute or market-beating returns are increasingly turning to hedge funds. But market scandals in the U.S. and investor lawsuits in Europe have made these conservative institutional managers wary. Consulting firm BearingPoint says that operational issues account for more than half of hedge fund failures, and associated reputational risks could keep institutional money from flowing their way. With SEC oversight powers up in the air because of a recent court decision invalidating the hedge fund registration rule, self-policing and investor due diligence will have to take up the risk management slack.

Christopher Kundro and Stuart Feffer, managing directors and co-heads of the wealth and investment management practices for BearingPoint, claim to have introduced the phrase Ooperational riskO at a hedge fund conference in Switzerland around three years ago. OWe represent very, very large institutional investors, and hedge funds have to make disclosures if they want their business,O says Kundro. OAt the end of the day, large institutional investors say: OIf you want my money, answer my questions.O They have raised the bar on due diligence.O

Operational risk in a hedge fund is different than that in conventional asset management firms, where regulators have a say. The sell side, besides being closely regulated, disciplines itself by virtue of having millions of dollars of its own capital at risk.

OOn the buy side, the bets are all with clientsO money,O says Andrew Liegel, senior analyst covering risk management at Financial Insights in Framingham, Mass. OIf a fund manager does an awful job and loses 60 to 70 percent of the fund, it is not the firmOs money that is at risk, it is the customersO money. Of course there are potential lawsuits, and its reputation is at stake, making getting new clientsO money in difficult.O Kundro refers to what he calls OC1 riskON Owhere a hedge fund lands on page C1 of the Wall Street Journal because it blew up.O