Counsel members Beth Alter and Lauri Goodwyn authored an article titled, “Electronic Trading Agreements,” which appeared in the May issue of the Journal of Investment Compliance and is also posted on the Emerald website.

April 22, 2011
Journal of Investment Compliance

As prime brokers and other vendors offer a variety of electronic trading tools, hedge fund managers should understand how the agreements related to these tools operate. In this article, we discuss some of the issues a manager should consider prior to executing any electronic trading agreement (“ETA”) with a prime broker.

Historically, trade execution was a physical business. Trades were executed on exchanges with hand signals and shouting into trading pits or rings. The introduction of electronic trading and order routing in the 1990s dramatically changed the business landscape, moving significant business away from trading floors to electronic trading platforms which offer, among other benefits, faster execution, lower fees and more access to the marketplace. Since the advent of electronic trading, a wide array of services for different products offered by numerous providers has proliferated.

In the limited context of prime brokerage, the issues associated with electronic trading vary by dealer, as the services offered are not consistent among all dealers and client needs are not uniform. In general, a manager should identify what s/he needs to conduct business. For instance, will the manager use systems offered by the prime broker or will the prime broker interface with trading and messaging engines utilized by the manager? Does the manager need a front-end interface to import information such as baskets from traders? Does the manager want to direct orders to specific markets? Is the capacity to conduct testing against historical data necessary? Does the manager require real-time access to positions, execution history and research? Is the ability to customize reports important? Does the manager have specific needs with respect to trade allocation?

When meeting with potential prime brokers, a manager should spend significant time discussing whether the brokers can completely integrate all of the systems used by the manager into the clearing process. In an ideal arrangement, all trades will be fully integrated, as partial integration raises operational, accounting and compliance risks. Although one might assume that proprietary systems offer seamless processing, a manager should dig a bit further. Some proprietary systems actually are repackaged third-party products and are not integrated fully into centralized clearing. Moreover, even where true proprietary systems are utilized, a prime broker may not have the capacity to integrate different products into central clearing and may require the manager to undertake trade reconciliations, position imports and related work. Similarly, to the extent that a manager is not using proprietary tools offered by the prime broker and the systems are not integrated, the likelihood of encountering operational, accounting and compliance issues increases. The concept of integration can apply to leverage as well. If a prime broker requires separation of long and short positions into separate accounts, the manager should investigate how positions will be consolidated and reported and how much work will be required from the manager to do so. To the extent manual labor is expended, one can reasonably expect operational, compliance and accounting risks to increase.

Although one might assume that ETAs are “standard” documents signed without comment, a manager should have the document reviewed by counsel to assess risks and liability prior to execution. Following are some considerations to bear in mind when negotiating ETAs in order to maximize value and minimize potential liability:

  • Scope of the license grant. Many ETAs grant a license to use an electronic trading platform for “internal business purposes only.” This may limit a manager’s ability to share information or reports generated through the platform with investors, third-party service providers or others outside the manager’s organization. If a manager will need to provide external reporting, the permission to do this should be explicitly granted in the agreement.Also, many ETAs provide that they are non-transferable. Since hedge funds are comprised of many related entities, there are often several different entities which may need to use the trading platform. The agreement should therefore provide that it is transferable to these entities, or these entities should be made parties to the agreement.
  • Warranties. Many ETAs state that the platform is provided “as is” with no warranties. This means, among other things, that the prime broker is not guaranteeing that the platform will perform properly or even that it has the right to license the platform. Managers should negotiate at a minimum for guarantees that the prime broker is taking commercially reasonable steps to ensure that the platform is free of viruses and other harmful code that could hinder its performance or damage the manager’s computer systems, and that the platform does not infringe upon any third-party rights.
  • Indemnification/limitation of liability. Generally speaking, the ETA should provide at minimum that the prime broker will indemnify the manager if the manager is sued for infringement based on the manager’s use of the platform as authorized in the ETA. Any damages caused by the prime broker should be carved out of the manager’s indemnification of the prime broker. In addition, any limitations on the prime broker’s liability should be made mutual and gross negligence and willful misconduct should be carved out of any limitations on liability. Each case is unique, however, and managers should discuss the indemnification and limitations of liability provisions of ETAs with counsel.
  • Security. In order to ensure that the manager’s data is protected, the agreement should provide that the prime broker will maintain at minimum commercially reasonable security measures to prevent third-party access to the manager’s data and any manager passwords for the platform.
  • Confidentiality. The agreement should include an acknowledgment by the prime broker that the manager is the owner of the manager’s data and that the prime broker will not use it or disclose it to any third party.
  • Maintenance. The agreement should provide service-level guarantees from the prime broker that address how quickly and how extensively the prime broker will respond in the event of a malfunction.
  • Customizations. If the prime broker will be customizing the platform for a manager, the manager should ensure that the agreement specifies who will own the customizations and what restrictions, if any, there will be on use or third-party use of the customizations. Many agreements provide that customizations are owned by the prime broker, even if they were developed for a specific manager. This could result in the prime broker licensing customizations designed specifically for a particular manager to the manager’s competitors. If a manager wants to own the customizations, or if the manager wants to ensure that any customizations developed for the manager but owned by the prime broker are not licensed to the manager’s competitors, those issues should be explicitly addressed in the agreement.
  • Termination. Many ETAs provide that all copies of the platform and all other prime broker materials shall be returned to the prime broker or destroyed upon termination of the agreement. In the event that the manager will require access to data that is stored through the platform following termination of the agreement, the agreement should address how the manager will be able to retrieve data following termination of the agreement.

In conclusion, prime brokers offer numerous electronic trading and routing options to assist a manager in conducting business. Prior to signing any ETA, a manager should undertake a two step process to assess the fund’s needs and to confirm that the applicable prime broker can service such needs to the manager’s satisfaction. Although ETAs appear to be boiler-plate non-negotiable documents, many dealers will amend them to some degree. Even in the limited instance where a prime broker absolutely refuses to amend an ETA, counsel should review the contract prior to execution as many ETAs impose various obligations on a manager, prevent him/her from conducting business as expected or required and significantly limit the prime broker’s liability.


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