08/11/2010

European Hedge Fund Regulation

By José Botella, Adviser on the Economic and Monetary Affairs Committee

The financial crisis has exposed a series of vulnerabilities in the global financial system. It has highlighted how risks crystallising in one sector can be transmitted rapidly around the financial system, with serious repercussions for all financial market participants and for the stability of the underlying markets. The Hedge Funds Directive forms part of an ambitious EU programme, in line with the G20 commitments, to extend effective regulation and oversight to all actors and activities that embed significant risks. The purpose is to establish a secure and harmonised EU framework for monitoring and supervising the risks that Alternative Investment Fund Managers (AIFM) pose to their investors, counterparties, other financial market participants and to financial stability itself.

In the EU, investment funds can be broadly categorised as UCITS (Undertakings for Collective Investments in Transferable Securities) and non-UCITS (or non-harmonised) funds. The former are those that comply with the harmonised rules laid down in the UCITS Directive and are authorised for sale to the retail market. For the purposes of this Directive, Alternative Investment Funds (AIF) are defined as all funds that are not harmonised under the UCITS Directive.


Purpose of this Directive

The AIF sector is of significant importance to the EU, with around €2 trillion in assets at the end of 2008. It is also diverse: hedge funds, private equity funds, commodity funds, real estate funds and infrastructure funds, among others, all fall within this category. They invest in a wide range of assets and employ different investment strategies and techniques. AIF invest in financial instruments such as stocks, bonds and other securities or commodities, as well as shares in real estate and infrastructure projects and controlling stakes in companies.

Investments in AIF are typically regarded as entailing a level of risk or other characteristics that render them unsuitable for retail investors. Access to many types of AIF has therefore traditionally been restricted to professional or institutional investors.

The activities of AIF Managers are currently regulated by a combination of Member State financial and company law regulation, as well as cross-cutting provisions of Community law. These laws have been supplemented in some sectors by industry-developed standards. However, the crisis has demonstrated that the activities of AIFMs are not sufficiently transparent and that the associated risks are not sufficiently addressed by current regulatory and supervisory arrangements. Crucially, the existing regulatory environment does not adequately reflect the cross-border nature of the risks posed.

The nature and intensity of these risks varies between the different business models that AIFMs pursue. For example, macro-prudential risks associated with the use of leverage relate, primarily, to the activities of hedge funds and commodity funds managers; whereas risks associated with the governance of portfolio companies are most closely associated with private equity. However, other risks, such as those relating to the management of micro-prudential risks (in particular to the internal risk management systems of the AIFM) and to investor protection are common to all types of AIFM. The risks associated with their activities have manifested themselves throughout the AIFM industry over recent months and may in some cases have contributed to market turbulence.

While AIFMs were not the cause of the crisis, they have in some cases contributed to market turbulence. For example, hedge funds have contributed to asset price inflation and the rapid growth of structured credit markets. The abrupt unwinding of large, leveraged positions in response to tightening credit conditions and investor redemption requests has had a procyclical impact on declining markets and may have impaired market liquidity.

Funding for hedge funds has faced serious liquidity problems: they could not liquidate assets quickly enough to meet investor demands to withdraw cash, leading some hedge funds to suspend or otherwise limit redemptions.

The Directive introduces harmonised comprehensive and effective regulatory and supervisory framework for Alternative Investment Fund Managers (AIFM) in the EU.


The European Passport. Third country regime

Since the European Commission adopted its proposal on April 2009, intense negotiations have been necessary to conclude an agreement between the two co-legislators; the European Parliament and Council. Jean-Paul Gauzés, who is Rapporteur on the dossier, has been in negotiations with three consecutive Council Presidencies; Sweden, Spain and Belgium during the last 15 months, since the report was adopted by the Economic and Monetary Affairs Committee of the European Parliament. The most difficult topic has been the third country regime.

Once they have been authorised, AIFMs should be able to manage and market their funds, established in the Union, to professional investors throughout the territory of the Union. Such a European Passport should make it possible for any fund established inside the Union and managed by an authorised manager in its home Member State to be marketed, subject to a simple notification procedure, in all Member States. This European Passport will be introduced in 2013.

With regard to third-country AIFMs and third-country funds, the text provides that an AIFM established in a third country may provide management services on the territory of a Member State provided that certain conditions are satisfied by the third country where the AIFM is established (anti-money laundering standards, agreement for effective exchange of information for tax matters with that Member State, reciprocity of market access) and by the AIFM and its competent authority (agreements between the AIFM and the European Securities and Market Authority (ESMA) and between the competent authority of the AIFM and ESMA). This European Passport for non-EU AIFMs will be introduced in 2015.