Fools and regulations
3 May 2010
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8 November 2010
The EU’s attempt to regulate hedge funds and other alternative investment vehicles runs the risk of damaging Europe’s fragile economies at a crucial time in their recovery, warns Henry Smith
European efforts to regulate hedge funds and other alternative investment vehicles run the risk of fragmenting the global financial regulatory system at a time when the Continent’s economies can least afford it.
The European Commission’s draft Directive on Alternative Investment Fund Managers has already had a damaging effect. Fund managers fear they will be unable to comply with many of the directive’s provisions and European pensions are worried about being prevented from investing outside EU boundaries.
If these nascent trends gain momentum, liquidity in global financial markets could drop as European capital is drained from global financial markets.
This outcome is not far-fetched given the fact that more than 70 per cent of the world’s hedge funds are based in or managed from ’third countries’, the term used in the directive for non-EU jurisdictions. A letter to the European Parliament from a group of Dutch pension plans showed that the largest plans among them place 97 per cent of their hedge fund investments and 75 per cent of their private equity fund investments with third country funds and fund managers.
These European investments in third-party funds channel private capital into global financial markets whose health is necessary for economic growth in emerging markets, as well as in the developed economies.
This capital provides credit to companies and consumers as well as countries that rely on sovereign debt markets to finance public expenditures. Investment fund managers and other service providers located in the EU earn fees from providing services to international investors in Cayman Islands investment funds, thus supporting jobs and generating taxable revenues in EU member states.
But it is not the plight of hedge fund managers or the fear of another credit crunch that worries the Dutch pension plans: it is the plight of the pensioners for whom they are managing retirement assets.
The Dutch warn that the directive could lead to an “undue reduction of investment opportunities, higher costs and lower returns for investors”. They estimate that the directive could lead to an annual net loss of nearly e1.5bn (£1.29bn) in investment returns and force them to raise pension contributions by 6 per cent.
Worse, some of the proposals on the table set nearly unattainable standards for even the best international funds; so many fund strategies, such as emerging market funds and funds of hedge funds, could become virtually inaccessible to EU investors.
Why, at a time of financial hardship, depressed consumer spending and yawning pension and public sector liabilities, would the EU introduce such potentially damaging legislation into a vulnerable global economy? One possible reason is a desire to control access to alternative investment funds, which are often unfairly blamed for financial market volatility. Another possible reason is a preference for a specific European solution.
Current drafts of the directive have introduced provisions that could mitigate some of the worst impacts of the original proposal, such as by enabling third countries to establish that their regulatory oversight conforms to international standards.
In theory, this would allow non-EU funds and fund managers to qualify for an EU-wide passport to market investment funds. However, the failure to define the international standards clearly will cause uncertainty.
One suggested approach would be to base assessments of third country regulatory regimes on standards set by organisations such as the International Organisation of Securities Commissions, which has scrutinised regulatory regimes worldwide for compliance with best practices for securities regulation. This approach would keep the European markets open to global funds and fund managers while also setting a globally consistent standard.
Mario Draghi, chairman of the Financial Stability Board, a global regulatory body that handles G20 initiatives, recently warned Brussels of the risk “that countries and regions will go their own way and that the [financial] system will fragment, with very significant global costs”.
Meeting global standards
Many third country funds already meet high international standards. Cayman authorities, for example, share tax information and cooperate with regulators in many other countries.
A 2009 International Monetary Fund report praised Cayman for implementing a regulatory framework for investment funds that is consistent with top international standards. It is this body of international due diligence that members of the European Parliament and European national governments should take into consideration when drafting their preferred standards.
If a third country fund manager is unable to comply with all the components of the directive and is not granted an EU-wide marketing passport, then a way forward might simply be to continue to allow European investors to access third country investment funds through individual member state private placement regimes. European investors could then choose to invest in investment funds on the basis of the quality of the product and service providers and not on the basis of geographical criteria, as envisaged by the original proposed directive.
The international investment community would support effective and proportionate regulations that address global systemic risk issues. But any new regulation should preserve institutional investors’ freedom of choice for the benefit of European and global financial markets and the generations of European pensioners that they serve.
Encouragingly, this appears to have been recognised by many MEPs and national governments and is reflected in a number of counter-proposals to the Commission’s draft, but much work remains to be done. Without proper amendments, the directive could have painful unintended consequences for investors and global economies.
Henry Smith is global managing partner at Maples and Calder