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Cicero Policy BrieferIssue 3, August 2006
Thorny issues: What is the future of hedge funds and
regulation in Europe?
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| “Hedge funds are one of the most interesting and vexing questions for the Commission” |
Hedge funds are one of the most interesting and vexing questions for the Commission. The growth of EU-based hedge fund management has been significant. According to the Expert Group Report, the size of the funds located in or managed from Europe has increased from just under €50bn at the end of 2000 to approximately €325bn at January 2006. This now accounts for around 25 per cent of all hedge funds in the world, more than two and half times the amount managed only three years ago. This marks a considerable shift away from hedge fund management activity in the last decade, which was almost exclusively the preserve of US managers and offshore European managers.
At issue is how to balance two competing objectives.
Firstly, there is a strong desire to continue this exceptional record of growth and create the best conditions for this sector to flourish in Europe. This will only be done by ensuring the right regulatory framework for a truly global industry. The goal of a lasting solution appears especially opportune given the fluid and uncertain regulatory landscape for hedge funds in the US. Recent SEC decisions have met with disdain amongst fund managers.
However, that desire must be weighed against the obligation of the Commission and regulators to provide adequate protection for consumers. These consumers are in some cases demanding exposure to hedge funds outright and in other cases finding themselves exposed through the choices and diversification of their pension investments by institutional managers.
The industry-based expert report makes some very sensible suggestions. Of their 11 recommendations, most are worthy of serious consideration, and will duly be given it as the Commission pulls together November’s white paper.
The most significant suggestion is that there are no additional restrictions on the funds’ mechanics, manufacture and registration. To do so would undermine the very essence that is the innovation and international nature of hedge funds. Instead of product regulation, the Expert Group suggests focussing on investment services rendered, ensuring that they are MiFID-compliant. Commissioner Charlie McCreevy alluded to this — a question about the extent to which MiFID can apply. He has referred this matter to experts at the Commission.
In lieu of product regulation, the group suggests two important measures as additional means of control. First, there should be a minimum threshold of €50,000 for individual investment. The group also suggests enforcing conduct of business requirements on the distributor and intermediaries who conclude the contracts with the investors.
One of the thorniest issues is whether to expand the UCITS directive to include hedge funds. The group was divided on this issue, with some feeling that now is the time to include hedge funds as UCITS-compliant. The majority of the group felt that this was not the time to widen the scope of eligible funds, while others were in favour.
Other recommendations include ensuring virtually seamless cross-border sharing of services, establishing a protocol for mutual recognition, further communication and agreement of cooperation with the SEC in the US and certain further exclusions or special arrangements regarding the treatment of investments in hedge funds as it relates to the implementation of the IORP, CRD and Solvency II Directives.
While it is certain that the forthcoming white paper will make some changes to the retail funds regime, the verdict is still out on hedge funds. Most use offshore structures, a continuing area of concern for Member State regulators which Commissioner McCreevy has labelled a “commercial and regulatory challenge”. Should single hedge funds have direct retail accessibility? If so, McCreevy was clear that they will be regulated and brought within a wider retail investments regime. The desirability of such a development according to the Expert Group is almost nil — it makes an extremely strong argument about the sensitivity of funds to regulatory change.
However, retail investors may become more exposed to hedge funds and techniques. There is an increasing demand from pension funds and others for these holdings. According to Commissioner McCreevy, UCITS are being squeezed because investors are seeking more complex products.
This raises a most perplexing question: what of the growing tension and market shift between UCITS and hedge funds? There is certainly a lack of common treatment which is widely accepted: huge variation, for example, on vital issues such as investor eligibility and classification, legal structures and so on, for what are essentially the products using the same techniques. Within UCITS, various restrictions or limitations can be subverted by using structured products. But is that better for the investor? Or in the words of Expert Group Member Odette Cesari, of AXA-IM: “Are we satisfied with that situation?”
Jacob Coy can be contacted on +44 (0)20 7665 9535 or click here to email.
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