Public Comments Support European Commission Proposal on Hedge Fund Regulation

There is a general consensus that hedge funds should be regulated as part of systemic risk regulation, according to public comments on the European Commission’s proposal to regulate hedge funds, but there is also a fear of regulatory arbitrage if such regulation is not global. There were 104 comments from a wide range of public authorities, financial organizations and investors. Although some prudential reporting to regulators is currently required, a large majority of commenters believe that regulators do not have enough information to monitor hedge fund trading activities. To that extent, transparency and disclosure by hedge funds to regulators should be improved and harmonized.

The European Commission recently endorsed a High Level Group report setting forth a broad blueprint for a complete overhaul of financial regulation in the European Union, including the regulation of hedge funds. Similarly, the G-20 recommends systemic risk regulation that includes hedge funds.

The comment letters revealed a general acceptance of the fact that hedge funds may constitute a source of counterparty risk to core financial institutions and the broader financial system as a consequence of sudden and large scale liquidation of hedge fund positions. In deciding the important question of the criteria for judging the systemic importance of a fund, most commenters said that the systemic risks of hedge funds should focus more on leverage. In assessing possible stability impacts, this perspective should take into account assets under management, number of counterparties, level of leverage, and volume of trading.

Many comments favored a single, global registration procedure for hedge funds and their managers as a starting point for improved transparency. Hedge funds could also be required to deliver periodic regulatory reports of appropriate information on, for example, size, investment style, exposures, leverage and performance. It was suggested that the information collection process could involve hedge fund managers as well as prime brokers, the valuator, the clearing broker or other central counterparties.

Importantly, a majority of commenters are not convinced that a purely EU response is likely to be successful. They feel that it may even have adverse effects on the European asset management industry, exposing it to regulatory arbitrage. A heavy-handed EU response not matched by action elsewhere could drive business away and reduce the competitiveness of the EU asset management industry. Given the interconnectedness of global financial markets and the international dimension of hedge funds, said many comments, any effective answer must be taken at a global level.

Other commenters said that the superiority of international action must not be an excuse for European passivity. Europe is home to a major alternative investment management industry and represents a substantial client base for this industry. Further, an EU framework could serve as a reference for global regulation of alternative investment management activity. It would also help to enhance the attractiveness of the European asset management industry and to foster the spread of standards of best practices. Some commenters even perceived an EU initiative as a first step towards an international consensus on hedge fund regulation.

While there was broad support for short selling as a legitimate investment technique under normal market conditions, a large number of commenters said that there are a range of circumstances in which short selling restrictions could be justified. Almost half the comments acknowledged that short selling could potentially be used as a part of an abusive strategy.

There was broad support for enhancing risk management standards employed by hedge funds. There was a split over whether effective risk management could best be achieved through self-regulatory codes of conduct or mandated regulation. Those favoring regulation argued that the experience with self-regulatory codes has raised questions relating to compliance and enforcement which undermine their effectiveness. The existence of these codes has not been sufficient to prevent the emergence of concerns relating to the hedge fund industry.

It was agreed that indirect supervision through prime brokers could not fully substitute for the required direct regulation of some aspects of hedge fund risk management. There were many suggestions as to how hedge fund risk management could be improved. For example, there has been excessive reliance on theoretical models for assessing risk. Also, internal governance should be improved so that managers have the appropriate risk management systems and reporting mechanisms.

Separation of functions was seen as a way to reduce operational risk and the possibility of fraud, and misappropriation of assets. Thus valuator, administrator, auditors and custodial functions should be separated in order to avoid possible conflicts of interest. In addition, some respondents insisted that the assets of the fund should be segregated from those of the prime broker. If not, the interests of the former are exposed to the risk of the bankruptcy of the latter.

Some commenters, however, contested the perception of hedge funds as unregulated. Even at the EU level, aspects of hedge fund business and hedge funds themselves are subject to MiFID, the Transparency Obligations Directive and the Market Abuse
Directive. When they become members of trading systems, they are also subject to the rules of that platform including all relevant transaction reporting rules.