By Duncan Black
The hedge row
29 June 2009
11 October 2013
28 February 2014
31 January 2014
25 April 2014
8 November 2013
With hedge fund managers under scrutiny and regulation inevitable, the industry needs to practise effective self-regulation.
Not for the first time is it reported that Brook Street and St James’s are reverberating to the sound of expensive luggage being packed. Hedge fund managers are retreating to the more congenial surroundings of Zurich and elsewhere to carry out their mysterious activities. London no longer has the advantages needed for this misunderstood trade.
UK tax increases were the first dark clouds, but the real blow is the proposed clunking fist of regulation. On this occasion the regulation comes not from Gordon Brown or the Financial Services Authority (FSA), but from the European Commission.
In April 2009 the Commission published its proposed directive on alternative investment fund managers. It has caused a storm of protest among the alternative asset management industry in London. The City minister Lord Myners is quoted as saying the proposal is “fundamentally flawed and bad for London” and that he is going to push for amendments so that the hedge fund industry does not “go the same way as our coal communities”.
The concept of regulating hedge fund managers is not new. The FSA has regulated London-based managers for many years, unlike in the US, where many managers remain outside the scope of supervision by the Securities and Exchange Commission (SEC) and other such bodies. The funds (unlike their managers) tend to be domiciled in tax havens such as the Cayman Islands. The Commission’s directive will continue with the process of regulating funds through managers. So far, so good.
The problem is with some of the detail. Top of the list of unpopular proposals is the requirement that depositaries should effectively be strictly liable to investors for anything that goes wrong. This puts a huge burden on depositaries. Hedge funds can only be marketed to sophisticated and high-net-worth investors and institutions. They are not a retail product for Joe Average. Yet the proposed liability of depositaries is stricter than that currently required for retail funds. It seems strange to require a greater degree of investor protection for investors who are, one assumes, ready and able to take greater risk.
Another proposal is that an offshore fund may not be marketed in the EU unless its country of domicile complies with the Organisation for Economic Cooperation and Development’s (OECD) ‘white list’ of tax jurisdictions that share tax information with onshore tax authorities. Currently this would exclude many jurisdictions where hedge funds are based. Leaving aside tax disclosure, in other areas hedge funds will be required to reveal more about their strategies and portfolios and their ability to rely on leverage (borrowing) will be restricted. The cost of complying with all this criteria will be substantial.
But cost is, I suspect, not the biggest issue. The real question is why this increased regulation is necessary. Everybody - including the departing EU commissioner and the FSA - agrees that hedge funds were not the cause of the 2008 meltdown; if anything, they were among the victims of the credit crunch. Many regulators around the world have from time to time tried to point the finger at hedge funds, but efforts to prove them guilty have failed. A good example was the ban on the short-selling of stocks in the UK, the US and elsewhere. These bans have in the main been lifted. Both the FSA and the SEC have admitted that preventing short-selling was with hindsight a waste of time. Short-selling is a common technique of hedge fund managers and in years past has been commended as beneficial because it assists liquidity and transparency of pricing in markets.
Hedge funds have for some time been aware that there was a risk of such a proposal being forced upon them. The Hedge Funds Standards Board (HFSB) - a committee of prominent hedge fund managers - was launched to deal with this and in early 2008 published a code of conduct for managers. The idea was that managers would sign up or opt out and that, with self-regulation, standards of disclosure and governance would improve because investors would look for the HFSB seal of approval.
Unfortunately take-up has been patchy. There has also been some duplication and complication, as a number of other industry bodies have published their own codes of conduct that partially overlap. It is now difficult to see a future for voluntary codes of conduct given that a directive in some form is widely regarded as inevitable. But despite the criticisms of the draft directive, what HFSB and its peers did achieve, I suspect, is a somewhat better set of proposals from the Commission than might otherwise have been the case.
What the alternative asset management industry must now do is unite behind a simple message and a coherent set of alternative proposals tolerable to the political forces that are determined to impose regulation, while at the same time preserving as much as possible the benefits of the current framework of FSA regulation.
Duncan Black is a financial services partner at Field Fisher Waterhouse