UK FSA Official Criticizes Protectionist Nature of EU Hedge Fund Directive

While generally supporting the European Commission’s proposed Alternative Investment Fund Managers Directive, FSA Asset Management Division Leader Dan Waters said that the Directive must embrace a global approach that recognizes the cross-border nature of the hedge fund industry and does not restrict investor choice with unjustifiable geographic restrictions. At a hedge fund regulation forum, he called ``misplaced’’ the Directive’s restrictions on the delegation of management services, custody and depositary activity. He similarly scored the blanket prohibitions on the marketing of non-European funds to professional investors.

The FSA leader noted that the UK has successfully permitted non-EU funds of various types to be marketed locally for a number of years. At the same time, the FSA has banned the marketing of hedge funds to the retail market, while permitting them to be marketed to institutional and sophisticated investors and sold on an advisory basis. The FSA believes that this approach provides an appropriate level of investor protection without unduly restricting investor choice and access to specific investment management expertise.

He contended that the proposed ban on non-EU funds and managers would restrict the access of European investors to valuable markets without justification. This radical departure from current arrangements would also create real practical problems for investors and limit their ability to benefit from the diversification offered by the alternative investment fund sector. The problems and complexity with these proposals would be exacerbated by the proposed restriction on the marketing of non-EU managed or domiciled funds three years after the date for Directive transposition.

In addition, the scope of hedge fund marketing under the Directive includes the situation where the investment is made at the initiative of the investor. The result of this would place a non-EU investment manager in breach of the Directive as a result of accepting an investment from an EU investor. The proposed Directive is protectionist, emphasized the official, and invites retaliation from other global markets.

Further, the Directive would only allow an EU credit institution to perform the custodian or even sub-custodian function. This would concentrate custody risk in the hands of a small group of institutions, reduce competition, and would not fit with the current legitimate population of prime brokers, few of which are EU credit institutions.

The FSA does not believe that the depositary function needs to be restricted to EU credit institutions. Prime brokers and investment banks should continue to be able to provide this service as long as they are suitably regulated. Requiring the depositary to be an EU credit institution and restricting delegation only to other EU credit institutions would effectively prevent alternative investment funds of all types from investing in non-EU markets with local custody requirements. The use of multiple prime brokers with depositary functions might also be difficult.

While agreeing with the Commission that regulators need to do more to control the risks of excessive leverage, the FSA official said that imposing arbitrary leverage caps on hedge funds is a simplistic approach that would not capture the fact that leverage can take many forms. Instead, the FSA urged the Commission to empower regulators to intervene in a tailored way when they identify particular risks.

The US Congress has not yet finalized draft legislation regulating hedge fund managers, noted the FSA official, but seems likely to incorporate manager authorization and disclosure requirements to the SEC. Both these are already in place in the UK. Congress appears to have no intention of following the more onerous protectionist elements of the proposed Directive with regard depositary requirements, leverage caps, and delegation restrictions.

With regard to the disclosure by hedge funds of systemically important information, said the senior official, the FSA is working with the SEC to identify a common, coherent set of data to be collected from hedge fund advisers and managers. As regulators of the financial centers in which the vast majority of hedge fund assets are managed, said the FSA official, the SEC and FSA will harmonize the collection and sharing of this information in order to reduce the compliance burden on fund managers while allowing the agencies to better identify risks to their regulatory objectives and mandates.

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