KATHLEEN CASEY, CHAIRMAN, AIMA
Strong and effective regulation plays an important role in supporting the depth, vibrancy and resilience of our financial markets. But, to be strong and effective, that regulation must serve a demonstrated need and be grounded in market understanding, workable, proportionate and, increasingly, based on global coordination.
As the post-crisis regulatory architecture takes shape, it is clear that these goals are not being fully met. A number of important issues remain to be resolved, from the scope and proportionality of new proposals to practical difficulties such as cross-border harmonisation. There is clearly a lot of work to do, and AIMA will continue to work with policymakers and regulators on reaching workable reforms as well as assisting the industry in understanding and complying with the new regulatory landscape with the help of practical toolsets and educational resources.
While there is a tremendous amount of regulatory change underway across major jurisdictions and new developments looming on the horizon, this article focuses on the three most significant regulatory changes currently facing the global hedge fund industry: the Alternative Investment Fund Managers Directive (AIFMD); prospective additional requirements for the ‘shadow banking’ complex; and the regulation of swaps in the US under the Dodd-Frank Act. Each one brings particular challenges to the industry.
When the European Commission published the final text of the implementing measures of the AIFMD in December 2012, it shifted the focus to a national level, with EU member states required to transpose the AIFMD into their national laws by 22 July 2013.
This removed some level of uncertainty, but the AIFMD is a complicated piece of legislation. It is very likely to be interpreted – and implemented – across the EU in different ways. These differences will often be trivial, but some will be significant. For example, we expect that, depending on where they are based, EU managers may have an additional 12 months in which to comply with the AIFMD. For non-EU managers, private placement regimes will still apply, but only if co-operation agreements have been reached between the manager’s national regulator and the European Securities and Markets Authority (ESMA). At the time of writing, very few such agreements were in place.
Even where comparative certainty exists, hedge fund managers still face complex strategic and operational choices. These will be challenging for even the larger and more institutionalised managers. For smaller managers, they are likely to prove particularly difficult. It is vitally important, not just for the hedge fund industry, but for the stability of our financial markets as a whole, that legislation such as the AIFMD does not raise costs or barriers to entry to a level that would make it impossible for smaller managers to do business. Still very much the lifeblood of the industry, they serve an important function in dispersing potential concentrations of systemic risk in financial markets.
In furtherance of its effort to assist manager members, particularly smaller managers in addressing these challenges, AIMA has initiated the AIFMD Implementation Project. The project is intended to provide guidance to the industry on complying with the AIFMD, create a forum for discussion within the industry on the practicability of the new requirements, and generate feedback on practical implementation issues that will be passed to policymakers. The various components of the AIFMD Implementation Project draw on the resources of some of our leading member firms, and we are extremely grateful to them for volunteering their time and expertise as part of the project.
One of the primary components of this project is an online self-diagnostic tool and detailed guide to implementation that we developed in partnership with PwC, the professional services firm. The diagnostic tool will enable AIMA members to track their compliance readiness, while the guide, which is being continually updated as different jurisdictions develop their national legal frameworks, sketches out the various strategic and business options both EU and non-EU managers should consider. These tools should help to cut through some of the complexity facing the industry, although individual firms will still need to talk through their options with their professional advisers.
As noted, the diagnostic tool and implementation guide are but one component of the AIFMD Implementation Project. We will also publish a handbook that will aim to provide guidance regarding the AIFMD’s requirements in areas of legal uncertainty. Different sections of the handbook will be drafted by different AIMA working groups, headed by many of our leading law firm members. This publication will appear once the national legal frameworks across the EU become clearer.
As the timeline above shows, the AIFMD will remain in a state of flux for some time to come. During the first half of 2013, ESMA is expected to finalise and publish guidelines and regulatory technical standards to further harmonise the implementation of the AIFMD by member states and managers. In 2015, the delegation requirements, which specify the functions that a manager can outsource to a third party, will be reviewed and, if they are found not to be working, altered. Also in 2015, a decision will be taken on whether to introduce the so-called ‘passport’ for non-EU managers, granting them access to the entire EU market if authorised in one member state. National private placement regimes will not be phased out until at least 2018, and may not be at all.
Moreover, this may be only the first of many iterations of the AIFMD. The Undertakings for Collective Investment in Transferable Securities (UCITS) Directive, first adopted in the 1980s, is on its fourth edition, and the latest set of proposed changes, referred to as ‘UCITS V’ and ‘UCITS VI’, are under consultation by the European Commission. The AIFMD may well go through a similarly extensive set of revisions. It is written into the AIFMD that the European Commission will start a review of its application and scope by July 2017. Amendments would most likely be enshrined in an ‘AIFMD II’, and so further reforms could lie ahead.
‘Shadow banking’ – as defined by the Financial Stability Board (FSB) as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system” – is another key area of policy and regulatory focus.
Following the onset of the crisis and an intensified macro-prudential focus on identifying systemic risks to the financial system, G-20 leaders instructed the FSB to develop recommendations to strengthen the oversight and regulation of the shadow banking system. There have been subsequent developments at a global and EU level. In November 2012, the FSB consulted on its initial set of policy recommendations and, significantly, included credit hedge funds as an example of an entity that in its view carries out shadow banking-like activities. The European Commission, which published a Green Paper on Shadow Banking last year, continues to consult on the subject. In the US, primary attention has been on potential vulnerabilities arising from wholesale short-term funding markets, such as money market funds, tri-party repo and securities lending.
While AIMA has supported the G-20’s objectives of strengthening the oversight and regulation of the shadow banking system, it has argued consistently that hedge funds do not operate in the shadows and nor do they, in general, perform bank-like activities. While there may be non-bank entities that can become a source of systemic risk, either directly or through their interconnectedness with the regular banking, clearing, payments or settlement systems, hedge funds are not currently among them. Indeed, the data obtained by regulators on the activities of the hedge fund industry should allow for an early detection of any trends to the contrary.
In informing the topic, AIMA has essentially sought to demonstrate how, in some very significant and fundamental ways, hedge funds differ from banks and traditional banking activity. Hedge funds do engage in maturity and liquidity transformations to some extent but, as the data below shows, the transformations often run in the opposite direction than what would be expected for a banking institution. Data from the UK Financial Services Authority’s 2011 hedge fund survey shows that the hedge fund liability profile is the inverse of that of a bank – ie, the funding maturity is longer than the liquidity of the risk portfolio. What this means is that assets of hedge funds could normally be liquidated in a shorter timeframe than the period after which their liabilities (to investors and providers of credit) would become due.
There are further well-established differences between asset managers and banks which warrant a differentiated regulatory approach. Hedge funds and their managers globally are already regulated and subject to extensive reporting by competent financial market authorities. They are small in relation to the rest of the financial system and in general operate on low levels of leverage. They are uniquely capable of managing their liquidity profiles so as to mitigate, not accentuate, pro-cyclicality. The industry is diverse, and hedge funds are ‘safe to fail’ and not in need of official government support. Hedge funds, individually or collectively, are therefore not ‘systemically important’ and can be seen as a stabilising, as opposed to a destabilising, element of the financial system. Moreover, hedge funds aid efficient price discovery and add liquidity to markets, thereby helping to cut the cost of financing and ensure that scarce capital goes to well-run companies.
From a risk management view, hedge funds use sophisticated risk management systems to ensure their long-term success, and managers are incentivised to succeed over the long term by reason of co-investment of their own money with their investors. Consequently, there exist strong incentives for managers to ensure that asset and liability mismatches are well managed. These are important and healthy risk-mitigating incentives and functions in our markets.
Taken together, these are extremely useful market strengthening characteristics, which ought to be protected, if not encouraged, by any further regulatory efforts. Ultimately, extending banking or bank-like micro-prudential regulation to activities, such as asset management, risks undermining the very financial stability and economic growth objectives that the G-20 and financial regulators seek to promote and achieve. Indeed, such an expansion to traditional market-based activities and entities is likely to result in reduced market transparency and discipline, increased regulatory complexity and greater homogeneous behaviour, all of which furthers, rather than diminishes, systemic risk and the existence of ‘too big to fail’.
In 2009, the leaders of the G-20 at the Pittsburgh Summit committed to ensure that, by end of 2012, all sufficiently standardised OTC derivatives would be cleared through a central counterparty; and all sufficiently standardised OTC derivatives would be traded on an exchange or electronic trading platform, where appropriate. Further, they committed to ensure that all OTC derivatives would be reported to trade repositories and that all non-cleared OTC derivatives would be subject to higher capital requirements. As a result, policymakers, legislators and regulators in the EU, US and Asia-Pacific have been developing regimes to fulfil these aims.
The 31 December 2012 deadline may not have been met fully, but the relevant regimes which have been, and continue to be, developed across the globe will increasingly enter into effect during the course of 2013 and 2014.
There is a strong financial stability argument for increased transparency in derivatives settlement, and mandatory central clearing, even though it would mean increased costs for the industry. However absent a rational and coherent approach to the global nature of derivatives markets, these regulatory objectives and stability goals are at risk. As regulators continue to build out their respective frameworks, the cross-border scope of requirements, inconsistencies in approaches between different regulators and the risks for duplication take on greater concern and urgency. AIMA has co-operated closely with the Managed Funds Association (MFA) and continues to engage intensively with policymakers in the US and internationally on constructive and workable solutions to these important cross-border and jurisdictional issues. As was stressed in a recent comment letter to the Commodity Futures Trading Commission (CFTC) in conjunction with the MFA, an internationally coordinated approach that ensures regulation reflects the global nature of the derivatives markets and promotes competition and innovation is vital to achieving G-20 objectives.
In the US, this is complicated by differing approaches to cross-border issues that continue to be contemplated by the SEC and CFTC. Further, the CFTC’s initial proposals take an expansive view of jurisdictional scope and do not adequately recognise the prerogatives and interests of regulatory counterparts and jurisdictions around the world. AIMA understands the need of jurisdictions, such as the US, to ensure that where the activities of an offshore fund or other market participant have a “direct and significant” impact on its economy and financial system, that they be subject to adequate regulation. At present, however, there remains too much of a presumption that a non-US entity will be subject to Dodd-Frank requirements. Longstanding and accepted principles of mutual recognition or substituted compliance, whereby an entity is deemed to be compliant with the US requirements if they are following comparable or ‘equivalent’ rules in their home jurisdiction, are particularly apt and necessary here. Failure to develop such an international framework that avoids the duplicative scope of the various international reforms will raise costs for the industry and may even lead to substantial regulatory conflicts that, if not resolved, could impair the derivatives markets.
Ultimately – and this applies to other policy and regulatory initiatives, not only provisions for swaps – it is paramount that bodies around the world continue to maintain an open dialogue and actively work toward developing harmonised regulatory frameworks or cooperative arrangements. Ensuring that regulations are the result of global dialogue and coordination will serve both the global development of financial markets as well as the ability of all regulators to oversee them effectively.