Tiago Ventura Mendes, LL.M. in European Banking and Financial Law, University of Luxembourg, LL.M. Candidate in International Financial Law, King’s College London
- The politically driven rationales to regulate hedge funds.
It is generally agreed that modern hedge funds have made their appearance around 60 years ago when Alfred Winslow Jones, a financially educated journalist, decided to invest in stock amalgamating long and short positions.[1] A hedge fund can be considered as being “any pooled investment vehicle that is privately organized, administered by professional investment managers, and not widely available to the public”.[2] The term “hedge” leads one to believe that one important characteristic of those funds is the usage of certain financial instruments for hedging purposes[3] in addition to engaging in other trading strategies seeking to protect themselves from adverse market movements[4]. They invest very actively in liquid public markets while using short-term investment strategies and sophisticated investment techniques as derivatives trading and short-selling but also enter in heavy leveraged transactions.[5] Hedge funds have been seen as playing fundamental roles in the market as contributing to market efficiency, promoting well-functioning corporate governance, unveiling fraudulent scandals and agitating boardrooms as active investors[6].
In the aftermath of the 2008 financial crisis, hedge fund managers’ financial techniques and market operations have become one of the main priorities of European legislators. The regulatory landscape has been changing dramatically under politically driven agendas all over the world and very importantly in the EU.[7] The rationale invoked by the European legislators and by national policy makers to tackle hedge funds are threefold as they supposedly seek better investor protection, market integrity and systemic stability.[8] Most grounds on which the regulatory evolutions are based have to be ruled out due to the fact that investors in a hedge fund are sophisticated and informed and are in a position to require adequate protection from their managers throughout the investment period.[9] As far as scandals like the Madoff scandal are concerned, they have badly tainted the hedge fund industry without justification. The investment structures were often registered and regulated with the national regulators and, in the majority of cases, the regulators had been given enough powers but they lacked enforcement initiative[10]. That inertia was confused with insufficient regulation. As for other market misbehaviour such as insider trading and market abuse, the EU has already established a sufficient legislative regime.[11]
It then seems that the only standing justification is the need to confront the problem of moral hazard. In case of default, hedge funds put their creditors, acting as credit counterparties, at risk when entering in high leveraged transactions. Likewise, when faced with volatility, these funds can be victims of sudden market reactions obliging them to liquidate outstanding positions very quickly.[12] By doing so, they amplify market volatility and instability – thus the necessity to provide a bigger investor protection and mitigate the systemic risk factor by enhancing transparency, supervision and risk management.
- The new regulatory framework.
One of the main responses emanating from the EU seeks primarily to establish a heavy framework applicable to hedge fund managers.[13] The first piece of legislation, the AIFMD (Alternative Investment Funds Managers Directive 2011/61/EU), was vigorously criticised by the hedge fund industry for its inadequate approach to regulation, not responding to the specific needs of the industry[14] and for curtailing its market operations. The Directive covers any “person whose regular business is managing one or more AIFs,”[15] but an exemption is given to managers managing smaller hedge funds with a portfolio not bigger than 100 million or 500 million euros when unleveraged and having limited redemption rights.[16] In order to be authorised under the Directive, managers have to provide a vast array of information concerning their investment strategies, risk and leverage positions.[17]
In order to be authorised under the Directive, managers have to provide a vast array of information concerning their investment strategies, risk and leverage positions.[18] Moreover, other requisites fall upon managers such as authorisation of management,[19] capital,[20] conduct of business,[21] delegation[22], marketing[23] and leveraging[24] requirements. Also, one single depositary has to be appointed.[25] For that heavy cost burden, EU hedge fund managers can profit from the EU Passport, allowing them to manage and market EU AIFs[26] in each Member State. The costs to comply with the Directive have been estimated to be consequent.[27]
Short-selling, as an investment technique used by hedge funds, was also condemned in the wake of the sovereign debt crisis. Hedge funds were accused of using this technique in a risky and destabilising manner.[28] The EU first made a proposal resulting in a final Short Selling Regulation (n° 236/2012) seeking to achieve better transparency by obliging the disclosure of net short positions on shares admitted to trading on a EU regulated market or MTF (Multilateral Trading Facility) and on EU sovereign debt as uncovered CDS derivatives.[29] Another objective was to tackle the risk of settlement failure.[30] Even if the thresholds have not been considered to be unreasonable, one might argue that public disclosure limited to positions in certain types of shares (like financial sector stocks), more specifically and in the sole presence of potential situations of abuse would be beneficial.[31] To mitigate the risk of settlement failure, it introduces a buy-in procedure combined with “locate” conditions that make the executions of naked short-sales more demanding.[32]
In addition, after being criticised for its opacity,[33] the OTC (Over-the-Counter) derivatives market has been firmly attacked by the EU with the adoption of the EMIR (European Market Infrastructure Regulation n° 648/2012) and numerous delegated regulations just after.
Hedge funds operating in the EU will be usually caught by EMIR as financial counterparties (FCs).[34] They will be required to clear derivatives, sufficiently liquid and standardised (“eligible” OTC derivatives[35]), through a recognised central counterparty (CCPs).[36] When an exemption to that obligation is available to hedge funds[37] (i.e. when the amount of the trading positions fall below a clearing threshold[38]), then another risk mitigation obligation applies.[39] A further cornerstone of the Regulation is the mandatory reporting of every derivative transaction concluded by all hedge funds[40] as a way to enhance risk transparency.[41] Unfortunately, these requirements inherently push the market to a significant level of standardisation of derivatives that leaves always less room for customised contracts where peculiarity is needed.[42]
As a complementary regulatory measure to EMIR, two additional pieces of legislation – MIFID II (The Markets in Financial Instruments Directive 2014/65/EU) amending the previous MIFID and MIFIR (n° 600/2014) – entered into force. The new Directive, which needs to be implemented in national law until June 2016, is bringing “standardised” derivative contracts from private markets to public markets by creating a new dedicated trading venue (Organized Trading Facility or OTF) – subject to authorisation – for present OTC derivatives.[43] The Regulation, which is directly applicable, imposes additional pre- and post-trade transparency requirements on the venues in which the derivatives are traded.[44] The impact of this legislation on hedge funds is still uncertain but already some further organisational requirements and trading limitations apply when hedge funds enter in HFT (High Frequency Trading).[45] It is also expected to influence considerably the ways in which hedge funds trade and the choice about where (i.e. in OTFs or in other markets) to trade.[46]
Furthermore, a proposal for a directive establishing a financial transaction tax (FTT) is still in the legislative pipeline[47] under enhanced cooperation.[48] It is aimed at slowing down high frequency trading and pure speculative trading.[49] Pursuant the standing proposal, hedge funds are expected to be caught by the directive[50] with their investment techniques and market operations (i.e. sale and purchase of financial instruments and derivatives contracts).[51]
- The undesirable consequences of the regulation.
As expressed previously, the financial crisis swept those funds from the previous lightly regulated landscape[52] to a very widely regulated and complex one. This new legislation, guided by unreasonable, populist and political motivations, was enacted in a rush and brings considerable costs with it. When establishing such a heavily regulated framework, one must ensure that its results tend to go in the expected direction. In fact, this is where many seem to disagree.[53]
On one hand, the UK, Luxembourg and Ireland[54] and the industry demonstrated their opposition to various new pieces of legislation[55] but, more particularly, to the first draft proposal of the AIFMD for being economically unrealistic and ill-suited.[56] On the other hand, the EU has reached a point where solely large hedge funds can withstand the numerous regulatory obligations by implementing important economies of scale[57] and at the same time, promise appealing returns to its investors.[58] The second or third tier players will hardly manage to stay in business, or enter the market, as the costs become unbearable.[59][60]
Ultimately, one is left with the impression that the hedge fund industry has been made majorly responsible for the financial crisis when it’s role was solely minor. The remaining valid reason to regulate hedge funds being the risk of systemic failure, big hedge funds will, on average, better cope with the requirements imposed by the regulation – reality that actually makes the default of one of them significantly more systemic.
Likewise, the fairly new EMIR is not bringing an effective and appropriate response to the risks emerging in the derivatives market. The Regulation obliges hedge funds to be more transparent about what they do at the expense of a better distributed risk among all derivatives counterparties in the market. Indeed, the obligation to clear the “eligible” derivatives within the clearing house will encapsulate the risk of multiple transactions in one sole entity via the legal mechanism of novation. In the event of default of the clearing house, the complications will spread to other entities very swiftly and are likely to cause a disruption in a considerable proportion of the derivatives market. When tackling the systemic risk aspect of hedge funds and the “too-big-to-fail” dilemma, the EU should have been more careful to not add much to the problem that it wants to address.
In addition, the current level of regulation is worrying as it might encourage hedge funds to seek for more convenient and lightly regulated jurisdictions from where they can operate. Some EU-jurisdictions, which have a good-sized hedge fund industry, are therefore more vulnerable to that predictable behaviour. To avoid such adverse and ancillary repercussions usually accompanying increases in regulatory pressure, one has to make sure that a significant part of the international community goes in the same direction and applies effectively equivalent standards.
Even if there are already some manifestations of regulatory fatigue, the EU still has to ensure that all the recent heavy regulations are in essence being well implemented. In practice, while European Securities Market Authority (ESMA) is busy drafting level 3 regulation, an imminent risk of EMIR overlapping with MIFID II/MIFIR emerges.
[1] Rappeport A. (2007), A Short History of Hedge Funds, CFO magazine, Available at: http://www.cfo.com/article.cfm/8914091. Accessed the 10th of December 2014.
[2] Report of The President’s Working Group on Financial Markets (1999), Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management.
[3] Chen, Y. (2010), Derivatives Use and Risk Taking: Evidence from the Hedge Fund Industry, Journal of Financial and Quantitative Analysis (JFQA), Forthcoming; EFA 2008 Athens Meetings Paper.
[4] Dixon L., Clancy N. and B. Kumar K. (2012), Hedge Funds and Systemic Risk, Santa Monica: RAND Foundation, p.11.
[5] Athanassiou P. (2009), Hedge Fund Regulation in the EU: Current Trends and Future Prospects, International Banking and Finance Law Series, The Netherlands: Kluwer Law International, p.14-16.
[6] Seretakis A. (2013), Taming the Locusts? Embattled Hedge Funds in the E.U., NYU Journal of Law & Business, P.123
[7] Hossein N. (2013), The Alternative Investment Fund Managers Directive and Hedge Funds’ Systemic Risk Regulation in the EU, p.4.
[8] Ibid., p. 7-8.
[9] Wood P. (2008), Law and Practice of International Finance, University Edition, London: Sweet & Maxwell, p. 339.
[10] Seretakis, op.cit., p. 127.
[11] It is now regulated by the Market Abuse Directive 2003/6/EC.
[12] Hossein, op.cit., p.8.
[13] Ibid., p.11.
[14] Payne J. (2011), Private Equity and Its Regulation in Europe, University of Oxford: Legal Research Paper Series, Paper No 40/2011, p. 21.
[15] Pursuant art. 4 of AIFMD, an AIF “is any collective investment undertaking which raises capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors and does not require authorization pursuant to Article 5 of the UCITS Directive (Directive 2009/65/EC)”. Art. 4 §1.(b) of AIFMD.
[16] Ibid., art. 3 §2.
[17] Ibid., art. 23.
[18] Ibid., art. 23.
[19] Ibid., art. 6 et seq..
[20] Ibid., art. 9.
[21] Ibid., art. 12.
[22] Ibid., art. 20.
[23] Ibid., art. 31.
[24] Ibid., art. 25.
[25] Ibid., art. 21.
[26] Non-EU AIFs will also from it from 2015 onwards. See art. 35 et seq. and art. 67.
[27] They are expected to amount to 3.2 billion euros initially and 1.4 billion euros per year as an ongoing compliance cost. See Malcolm K., Tilden M., Wilsdon T. and Resch J., Xie C. (2009), Impact of the proposed AFIM Directive across Europe, London, p.112-113.
[28] McGavin K. (2010), Short Selling in a Financial Crisis: The Regulation of Short Sales in the United Kingdom and the United States, Northwestern Journal of International Law & Business, p. 203.
[29] Payne J. (2012), The regulation of short selling and its reform in Europe, European Business Organization Law Review, p. 430.
[30] Payne (2012), ibid., p. 432-433.
[31] Payne (2012), op.cit., p.438.
[32] Seretakis, op. cit., p.143. See art. 12-13 of Regulation 236/2012.
[33] Ferrarini G. and Saguato P. (2013), Reforming Securities and Derivatives Trading in the EU: From EMIR to MIFIR, JCLS, p. 327.
[34] Art. 2 §(8) of EMIR. Referenced is made to AIFs as defined by AIFMD. See above.
[35] Art. 5 §(2)(a) of EMIR. The “eligible” OTC derivatives are detailed by ESMA in a delegated regulation.
[36] Ibid., art. 4.
[37] When hedge funds are qualified as non-financial counterparties (NFCs).
[38] Ibid., art. 10 and art. 11 of delegated regulation 149/2013 – 1 billion and 3 billion euros respectively.
[39] Art. 11 of EMIR. Either because it is not an “eligible” OTC derivative or the counterparties to the derivative transaction do not fall within the scope of the clearing requirement.
[40] Art. 9 of EMIR.
[41] Ferrarini and Saguato, op. cit., p. 334.
[42] Ibid., p. 335.
[43] Ibid., p. 353.
[44] Ibid., p. 355.
[45] Leonard C. (2014), After the AIFMD Apocalypse – The future for the regulation of hedge funds in Europe, The hedgefund journal.
[46] Ibid.
[47] See http://ec.europa.eu/taxation_customs/taxation/other_taxes/financial_sector/index_en.htm
[48] At the moment only 11 Member States agreed to move forward with the proposal.
[49] Seretakis, op. cit., p.146.
[50] Art. 2 §(1)(8) of the proposal COM/2013/71. Available at: http://ec.europa.eu/taxation_customs/resources/documents/taxation/com_2013_71_en.pdf. Accessed the 10th of December 2014.
[51] Art. 2 §(1)(2) of the proposal COM/2013/71.
[52] Wood, op. cit., p. 338.
[53] See for a short political outline: Arnold M., Masters B. and Tait N. (2010), Investing: Alternative visions, The Financial Times.
[54] See Parker G. and Jones S. (2010), Hedge funds vote threatens EU-US rift, The Financial Times. In fact, the UK share amounts to 80% of the hedge fund industry. See Hossein, op.cit., p.10.
[55] Concerning EMIR, See Barker A., Grant J., Parker G. (2011), UK faces defeat over derivatives clearing, The Financial Times.
[56] Arnold, Masters and Tait, op. cit.
[57] Morrison and Foerster Roundtable (2012), Outlook for Hedge Funds, Financier Worldwide Magazine.
[58] Cumming D., Dai N. and A. Johan S. (2013), Hedge Fund Structure, Regulation, and Performance around the World, Oxford Scholarship Online, p.54.
[59] As mentioned in the report of AIMA, MFA and KPMG International (2003), The 2013 Global Hedge Fund Survey – The Cost of Compliance, p.7.
[60] As a matter of fact, the hedge fund managers are expecting to spend between 5% and 10% of their operational costs on compliance infrastructure. See AIMA, MFA and KPMG International, op. cit.