Regulations adopted under the EU Alternative Investment Fund Managers Directive should define who is covered by the Directive and how the custody, prime broker, and depositary relationship will work as a function of the custody or verification responsibilities of depositaries, said Shelia Nicoll, Director of Conduct Policy at the UK Financial Services Authority. In remarks in Brussels, the Director also emphasized that existing regulations under related Directives should be adopted for the hedge fund directive when they relate to the same activities. She also urged that the many entities affected by the Directive be afforded the opportunity to give input, including prime brokers, custodians, depositaries, transfer agents, and auditors. This will be the first Directive where the new European Securities and Markets Authority (ESMA) will be providing the proposed regulations for the European Commission’s consideration.
The Directive was approved late last year and the European Commission has asked ESMA to draft regulations to flesh out the Directive. The Directive is aimed at enhancing investor protection and the identification, mitigation and monitoring of systemic risks arising from the activities of hedge funds and private equity funds. Following its implementation, the AIFMD will introduce: authorization and regulation requirements for hedge funds and private equity funds and regulatory standards for depositaries and administrators; minimum capital requirements related to portfolio size, governance and risk management requirements for fund managers. The Directive will also allow EU-wide marketing of hedge funds through a passport scheme, initially for EU fund managers only, and then to be extended to non-EU based fund managers two years later, subject to ESMA advice.
After due consideration of ESMA’s advice, the Commission will then adopt the regulations or not, if the Commission chooses not to adopt the draft provided by ESMA it is required to justify this position. The Commission can promulgate another Directive in place of regulations. The distinction is important. Member States can gold plate Directives during national implementation, which does not provide a maximum level of harmonization across the EU and can create an un-level playing field. Regulations, on the other hand, are directly applicable in each Member State.
The Minister urges the use of existing regulations when appropriate. While ESMA should think outside the box on some of these issues, noted the Minister, existing rules in the UCITS Directive, many of which have roots in MIFID, could be used as a basis for some of the proposed regulations under the hedge fund directive. When these rules relate to the same activities the existing rules should be adopted. This is a sensible approach, reasoned the Director, because many future alternative investment fund managers are already subject to the MIFID rules
More broadly, the Director said that regulators and policy makers must apply some critical thinking and ask whether a regime designed for retail investors readily applies itself to the professional fund space. While many UCITS firms also manage alternative investment funds the reverse is not true, noted the Director, since many hedge fund managers will just be running hedge funds. Thus, while existing UCITS managers may be able to apply many of the requirements in the AIFMD quite easily, the same cannot be said for non-UCITS managers.
The Directive is unclear on who will be considered an alternative investment fund managers. The Directive gives regulatory flexibility for the multitude of different legal and operation structures that fall into scope. For example, a hedge fund or private equity fund can either be internally or externally managed. Also, wiithin different types of funds, there is a continuum of responsibilities and actions taken by the governing body of the fund ranging from minimal involvement to day-to-day stock selection.
The Director said that ESMA must deal with three important policy issues on depositaries. First, it needs to explain when certain financial instruments held by a hedge fund are lost. Second, it needs to set out how the custody, prime broker, and depositary relationship will work as a function of the custody or verification responsibilities of depositaries. Third, ESMA regulations must explain how the relationship between service providers, such as the fund administrator, transfer agent, sub-custodians and depositary, will work as a function of the oversight and cash monitoring duties imposed on the depositary.