Making a Splash – Trends Across Cyber Security, AI, and the Regulatory Environment

Industry Insights:

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Industry Insights:

1. Top of Mind: Increased Scrutiny Around Hedge Funds’ Use of AI. The United States’ Senate Committee on Homeland Security & Governmental Affairs released a report on hedge funds’ implementation of artificial intelligence, “AI,” into their trading processes. They concluded that the current rules do not provide adequate disclosures to clients around how this could potentially increase risks to market stability.
   • Classification. Led by chairman Gary Peters, the report found that the existing regulations fail to classify AI technologies based on their associated risk levels. They argue that regulators have not sufficiently clarified how the existing regulatory framework applies to hedge funds’ use of AI. It also acknowledges that the inherent intricacy and opaqueness of these technologies make it difficult for managers to provide adequate disclosures to clients, especially regarding trading decisions.
   • Next Steps. The committee recommended several provisions for regulators, such as the SEC and CFTC, to implement. These recommendations aim to make regulations more uniform across the industry.
     • Managers are encouraged to reach out to their legal providers and make sure they classify when and where artificial intelligence is used in their processes.
2. CrowdStrike Outage: Bringing Vendor Assessment to Light. Given the events from earlier this July, many managers are on high alert of potential phishing attacks and placing an emphasis on the vendor relationships that they, as well as their service providers, are engaging in.
   • Risk Mitigation. Top of mind items for creating a safer technology ecosystem for fund managers include:
     • Implementing two factor authentication on all devices.
     • Reviewing the information security and business continuity plans of each vendor, while also inquiring on any past breaches.
     • Understanding internal risk management practices.
     • Researching the vendor with initial and ongoing due diligence.
   • Focus on Vendor Management. If a key vendor experiences a data breach, their client data is likely to be at risk as well. Many funds are now looking at their lineup of vendors and understanding which data they have access to and how to monitor this. Some managers are engaging with experts who can independently perform annual due diligence outreach on vendors’ cyber security processes.
   • SEC Action. The SEC seems to be extending their cyber focus to vendors as well, especially given recent cyber-attacks on these groups. The committee is aiming to show the importance of data integrity, confidentiality, and designing effective ways to report disclosures. The changes to the regulation SP also requires data breach notifications.
3. Regulatory Updates. Approaching this election year, regulators were eager to propose rulings across different functions of a firms’ lifecycle from employment, investor transparency, and operational considerations. Updates below:
   • Non-Compete Ruling. After the proposed rule was voted in by the FCA, many groups had challenged the ruling. It was granted a preliminary injunction earlier this July, meaning the final ruling should be decided this August. Although the outcome is unknown, many firms are continuing to operate as normal, whereas others are taking precautionary steps to be ready for the potential update of employment agreements.    
   • Outsourcing Rule. The vendor management rules highlight the importance of requiring registered persons to maintain oversight of their vendors. The expectation of this ruling is that documents will need to be kept that outline both the due diligence process taken and practices around the supervisory framework.
   • Private Funds Rule. The rule was vacated by the Fifth Circuit Court of Appeals on June 5^th. Although many were using the wait and see approach here, others used this time to reevaluate some of their processes associated with investor transparency.
4. FCA’s Sustainability Disclosure Requirements (SDR). The FCA’s Sustainability Disclosure Requirements came into effect in the United Kingdom this May. These “anti-greenwashing rules” aim to ensure that all sustainability related claims are “clear, fair, and not misleading,” and applies to all FCA-regulated firms, including alternative fund managers. Upcoming in the second half of 2024, there are some key dates that managers should be aware of.
   • July 31, 2024, firms will be allowed to use the FCA’s four sustainable investment product labels on their funds, with the appropriate disclosures to investors. Firms must notify the FCA if they choose to label their products. ESG labeling will go live as well.
   • December 2, 2024, firms must ensure the names and marketing materials for their sustainability labeled products are accurate and do not mislead investors.
   • Next Steps. Managers should review their marketing materials and update accordingly to ensure they are in compliance with the FCA’s SDR naming and marketing provisions. They should also prepare to meet the FCA’s disclosure requirements, which require managers to make available transparent information on their fund’s sustainability.

Please reach out to your Jefferies contact for more information on any of the topics above.

Client Corner:

Virtual Data Rooms. Our team has been fielding an increase in questions around virtual data rooms. While these initially gained popularity during the pandemic, they are now coming back into focus a reliable means of keeping data secured. We are seeing a mix of clients utilizing systems they are already users of, for example their CRMs, however many are also looking at stand alone and custom built offerings.

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Interesting Service Provider Reads: Highlighting Topical Content from Industry Leaders

Abacus – Understanding the SEC’s Amendments to Regulation S-P and The Aftermath of the CrowdStrike Outage: Essential Insights and Safety Measures

Akin Gump – Fund Managers Must Assess Whether Microsoft/CrowdStrike Outage Has Triggered Additional Regulatory Filings

Kleinberg Kaplan – Business as Usual for Now—A Reprieve from the FTC’s Nationwide Noncompete Ban

Seward & Kissel – CrowdStrike Outage and its Form PF Implications

SS&C – Cybersecurity and Rapid Response – Updates to SEC Regulation S-P

Jefferies Prime Services Contacts:

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