Europe doesn’t lack for rules governing hedge funds or hedge fund managers. Still, a movement is afoot to bring tighter regulation to the industry by forcing offshore funds to qualify for a European Union “passport” to do business in any of the coalition’s 27 member countries. Doing so would give the funds Continental access but require far greater — and more-standardized — transparency. The trade-off is already breeding opposition.
“Reporting transactions only increases bureaucracy and paperwork — it’s not going to help the industry,” grouses Stefan Löhr, a senior finance and energy portfolio manager at $1 billion-in-assets Zenit Asset Management, a Brummer & Partner’s hedge fund, which dates to 1996 and is the oldest hedge fund in Stockholm.
Europe today sports something of a patchwork of regulation that is confusing in itself. The U.K. is easily the most laissez-faire of all EU nations, its hedge fund regulations mimicking those in the U.S., whereas the Nordic countries have taken a more restrictive approach, Southern Europe remains a sleepy backwater, and Germany seems as hostile as ever to the industry. Berlin, in fact, is leading a fierce campaign to limit hedge funds, in part as a reaction to the global financial crisis but also because German authorities have never cared much for the industry in the first place (in 2005 the then-chairman of the Social Democratic Party, Franz Müntefering, famously characterized hedge funds as “locusts that come in and graze everything to the ground”).
It’s not as if certain Germans don’t sometimes act like hedge fund managers — witness billionaire Adolf Merckle, said to have lost almost $1 billion in late October when he shorted the shares of carmaker Volkswagen — but Germany frets that overly unfettered hedge funds have exacerbated the troubles of a market that is already rife with problems. Thus the country’s Social Democrats are demanding greater transparency and disclosure and pushing for the passport requirement.
Registration on its face might sound innocuous but for the fact that the Germans’ still-murky but ominous proposal would erect an assortment of barriers across Europe, requiring hedge funds that operate in the EU to disclose holdings, strategies, risk management practices and investors’ names. It would also bar funds from being listed on public stock exchanges, limit how much money pension plans and insurance companies could invest in them and prohibit leverage in excess of a 4-to-1 assets-to-capital ratio.
Should the EU adopt such restrictions — and it will probably adopt some of them — it will do so with two goals in mind: limiting the damage hedge fund investors can incur and standardizing the current mishmash with a single regulatory scheme.
“The emphasis is on finding common ground that protects investors and streamlines regulation — harmonizing hedge fund legislation within the EU,” says Manuèle Biancarelli, an attorney in the investment fund practice of NautaDutilh Avocats Luxembourg.
A tiny, landlocked country that has made much off its status as a tax haven, Luxembourg is more influential than its size would suggest. Officials there are on board as long as changes are EU-wide, the thinking being that standardization will further develop the European hedge fund market and benefit Luxembourg, which can use a reform program as a springboard to its already sizable hedge fund administration industry.
The template for much of the discussion is based on the Undertakings for Collective Investment in Transferable Securities, or Ucits, an EU edict that says, in effect, good enough for one, good enough for all. Under Ucits, banks and mutual funds have access to the entire European Union once they are approved by a member country.
Germany is not the only heavyweight pushing for more rules. In October, France was among 15 countries at the much-publicized Washington summit of the Organisation for Economic Co-operation and Development calling for a kind of blacklisting of nations that are known hideaways for nonregulated hedge funds — places like the Cayman Islands, Jersey and Switzerland. The initiative sought to punish such nonregulated funds by making them register piecemeal across the EU, nation by nation. The announcement seemed more about public relations than policy, but it may be a harbinger of tougher measures to come.
The Swedes have probably imposed more rules than anybody, barring unaccredited investors from Swedish hedge funds and requiring disclosure of investment strategies and relationships between bankers, brokers and funds. Lars Gavelin, director of equity and derivatives trading at the Swedish Ministry of Finance, notes that the government has advised against enacting additional regulations. But given this year’s economic turmoil and the demand for more oversight, Sweden isn’t likely to get in the way if other European countries lobby for a more universal set of rules. “We’ll have to go along,” concedes Gavelin.
The same is true of the U.K., which has the biggest finance-sector economy in Europe — and therefore perhaps the most to lose. With regard to regulation, London has always been U.S.-centric, favoring less government control. The U.K., like the U.S., this summer took steps to limit short-selling of financial stocks that were in free fall but — unlike the U.S. — has left its ban in place until January 16. And the Financial Services Authority, the U.K. equivalent of the Securities and Exchange Commission, was first to the punch, implementing its ban on September 12, a week before the SEC’s.
But because the U.K. derives so much of its income from finance, it is perpetually nervous about expanded regulation — of hedge funds, in particular — for fear of driving financiers to friendlier climes. Indeed, many European countries are onshore centers for offshore capital, so there is an underlying worry that more rules will mean less business.
“Any attempt to impose a more restrictive EU-wide regulatory framework of the nature proposed by the German Social Democrats is likely to run up against significant resistance because not all the national governments within the EU have the same interests in the matter of financial regulation,” says James Cole, a lawyer with London-based law firm Weil, Gotshal & Manges.
It is a complicated proposition too for a country or a coalition to legislate how to regulate investment of money that resides somewhere else, offers John Ryding, a former risk analyst with the Bank of England and former chief economist at Bear, Stearns & Co. “It’s difficult to regulate hedge funds when there are no constraints to the mobility of capital,” he says. But as the specter of global regulation increases, the demise of the hallowed hedge-fund tradition of locating in the least-regulated area seems increasingly possible.
The push for a more unified hedge fund code has considerable political support. In 2004 the European Parliament noted the growing participation of retail investors in the markets and sounded a note of caution about the increasingly “complex, wide-ranging set of services and instruments.” In September, Parliament passed a resolution that chided the European Commission, which is the executive branch of the EU, for not responding to earlier calls for more hedge fund supervision. The resolution recited a litany of complaints, including ones about “inadequate risk management, excessive debt (leverage) and the valuation of illiquid and complex financial instruments” and citing what it called “empirical evidence that hedge funds engage in herding in times of market turmoil, thus giving rise to financial-stability concerns.”
The resolution was preceded by an equally critical April report from Parliament’s Committee on Economic and Monetary Affairs, chaired by former Danish prime minister Poul Nyrup Rasmussen. “Not only amazing growth of their assets but also ever-more-intensive trading activities make these vehicles important market players,” it noted. “Although their weight in the market has increased, the same cannot be said for the levels of transparency.”
The report went on to say that current laws are “designed for the past,” and it called for more “reporting and disclosure, common standards for valuation, risk management, internal governance, etc.”
One force that proponents of pan-European regulation have on their side is the current economic meltdown and the accompanying backlash, which has only fanned the flames of reform. With elections coming up in a number of countries, “governments are trying to assure their constituents that they are attempting to bring the causes of the financial crisis under control,” says Sandra Navidi, a New York–based finance lawyer who advises a number of European multinational firms. What better way to do it than by cracking down on hedge funds, sometimes portrayed as black-box bogeymen of the free markets.
But the argument for more global control of hedge funds persists. “Even we economists who believe that global financial innovation yields huge net benefits must admit that today’s hedge fund boom is becoming like the tech bubble,” noted Kenneth Rogoff, a Harvard University economics professor and former chief economist at the International Monetary Fund, in a March 2007 Internet commentary that seems prescient now.
“The big question,” he wrote, “is whether this Wild West mentality poses broader risks to the global financial system, particularly given circumstances where a large number of firms are all making the same bet. If they lose, a long string of bankruptcies can cut deeply into banking systems that had generated huge profits by lending to these same hedge funds.”
The events of the past several months have proved him correct. Today he maintains that the U.K. and the U.S. are collectively the biggest obstacles to a more global system of regulation. It seems only fair to dispute that point, given the likelihood of a new layer of restrictions in the U.S., especially as a new administration takes office in Washington and Congress appears more likely to enact more hedge fund regulation. All that the Germans and their European allies are trying to do, he adds, is to look out for investors — an agenda that has the force of popular opinion.
In the assessment of Biancarelli, the lawyer in Luxembourg, “Investors are looking for more regulated vehicles — and they want greater protection.”
If a set of uniform rules and practices can achieve that, then, perhaps, so much the better.
See sidebar story, A New Norse Code: Foreigners Welcome.
