Regulations under the Alternative Investment Fund Management Directive must be balanced and non-protectionist, said Sheila Nicoll, Director of Conduct Policy at the UK Financial Services Authority. In remarks at a hedge fund conference, the Director said that the most contentious issue under the Directive is the treatment of funds and fund managers based in the US and other non-EU third countries. ESMA issued a separate consultation on its draft advice on these issues, covering supervisory co-operation, the marketing of hedge funds based outside the EU, the delegation of certain functions to non-EU service providers, and the appointment of non-EU depositaries.
There is concern as to the scope of the equivalence assessment that should be performed for the delegation of functions and the appointment of depositaries outside the EU. In drawing up its advice in this regard, said the Director, ESMA has to work within the principles inherent in the legislative text and, at the same time, ensure that a clear framework is set out in its proposed regulations. There are considerable sensitivities here, said the FSA official, not the least of which is ensuring consistency with international standards in respect of the cooperation arrangements put in place between regulators.
The senior official emphasized that the UK supports an approach acknowledging the global nature of the alternative investment industry. This approach should include fully embracing those international standards developed by IOSCO and other global standard-setters, but not doing so in a discriminatory or protectionist way. The UK does not want to see a line-by-line assessment of the equivalence of non-EU regulatory frameworks.
Moving to other issues, she noted that the liability of a depositary under the Directive for a loss of fund assets will depend on a number of factors, including the underlying cause of the loss and the reasonable efforts the depositary could have taken to prevent it. Some people want the regulations to focus on setting out those events that would result in a loss but for which the depositary could not have reasonably prevented, noted the Director, while others suggest that the so-called duty of care of the depositary should be based on the due diligence standards under the Directive.
In this regard, the European Securities and Markets Authority has worked on defining what ESMA has referred to as acts or omissions by the depositary. The purpose of this is to seek to provide further advice to the European Commission on this issue. The senior official said that the focus over the coming months will need to be on how these so called acts or omissions apply in cases of insolvency and fraud.
The Directive requires that fund managers and regulators set limits for the use of leverage. In this regard, said the Director, neither the industry nor the FSA will benefit from a blunt and poorly defined framework. There has been considerable debate as ESMA deals with the definition of leverage. While the concept of leverage ratios is familiar in the banking context, she observed, in the fund management arena this has not been an area subject either to definition or to regulation. One of the most difficult aspects of this work for ESMA is the need to develop an approach that satisfies two distinct objectives.
The first objective is to allow regulators to monitor the systemic importance or relevance of hedge funds and other alternative investment funds. The second is to allow investors to have a clear understanding of the leverage of the funds in which they are investing or are proposing to invest. The needs of these two different groups of users of the regulation, in terms of the definition and disclosure of leverage, are very different, said the senior official, and so developing a regulatory framework for this aspect has been challenging.
The comments on ESMA’s approach from respondents to the consultation were broadly aligned. Some suggested the approaches did not provide an appropriate indication of the risk and that VaR would be a better approach. Others said the approaches would be confusing and misleading for investors, while still others argued for more alignment with the approach adopted by the banking sector under the Capital Requirements Directive.
The senior official urged ESMA to carefully consider these comments in designing the final framework that it proposes to the Commission. In particular, it will need to decide how detailed it is going to be at this stage in advising the Commission on formal implementing measures. An option would be to include the more detailed definitions and calculations in further guidelines to be developed by ESMA.
Finally, the Director noted that the new Financial Conduct Authority will be the primary regulator of the UK hedge fund industry under the new regime replacing the FSA. In her view, the creation of the FCA provides an opportunity to develop a new approach to regulation and the scope to ensure a better focus on the distinctive approaches and skills required for good prudential and good conduct regulation of hedge funds. This approach will be particularly important for the fund management industry as the biggest constituency of firms for which the FCA will have responsibility for both prudential and conduct rules.