US Hedge Fund Industry Submits White Paper on Shadow Banking to European Commission

Hedge funds do not pose systemic risk and regulatory arbitrage risks, said the US hedge fund industry, and thus bank-like regulation of these funds is not necessary. In a white paper on shadow banking submitted to the European Commission, the Managed Funds Association cautioned that bank-like regulation of hedge funds would have the unintended consequence of placing unnecessary restrictions on the activities of hedge funds to the detriment of investors. The white paper detailed a litany of shadow banking characteristics that hedge funds do not share.

A characteristic of shadow banks is accepting funding with deposit-like characteristics. But hedge funds rely on long-term financing in the form of equity investments by investors, said the MFA, and such investments do not have deposit-like characteristics. Hedge funds build strong liquidity protections into their contractual relationships with investors. In particular, investors in hedge funds are subject to a variety of restrictions on redemption. As such, unlike money market funds, hedge funds are not vulnerable to runs by investors.

Another characteristic of shadow banks is performing maturity and liquidity transformation. But hedge funds do not rely on unsecured, short-term financing to support longer-term dated investing activities. Instead, hedge funds benefit from a stable equity base from investors. Hedge funds that make direct loans do not typically perform maturity transformation, said the white paper, because the liquidity profiles of such hedge funds are consistent with the medium-term nature of the lending strategy. For example, investors are subject to multiple-year lockups on redemption.

While another characteristic of shadow banking is credit risk transfer, noted the MFA, hedge funds do not typically act as originators or sponsors of structured finance vehicles and do not provide liquidity or credit support to such structures. Moreover, under the Alternative Investment Fund Managers Directive, hedge funds are prohibited from investing in securitization positions unless the originator, sponsor or original lender retains at least five percent of the securitization. Similarly, the Dodd-Frank Act imposes a five percent risk retention requirement directly on originators. Thus, credit risk transfer without “skin in the game” will no longer be possible. Although some hedge funds engage in derivative transactions, such as total return swaps, the counterparties are typically required to post collateral, which mitigates the credit risk to the hedge fund.

While acknowledging that hedge funds do use direct or indirect financial leverage, the association added that hedge funds are significantly less leveraged than other financial market participants. They will also be subject to leverage reporting requirements under the AIFM Directive.