Henry Smith |
By Henry Smith
European efforts to regulate hedge funds and other alternative investment vehicles run the risk of fragmenting the global financial regulatory system at a time when the Continent’s economies can least afford it.
The EU Commission’s draft Directive on Alternative Investment Fund Managers has already had a damaging effect. Fund managers fear they will be unable to comply with the Directive’s unreasonable provisions and European pensions are worried about losing access to investment opportunities outside EU boundaries. If these nascent trends gain momentum, liquidity in global financial markets could drop as European capital drains from investment funds. Refreezing financial markets just as they are beginning to thaw makes little sense.
This outcome is not far-fetched given the fact that more than 70 percent of the world’s hedge funds are based in or managed from “third countries,” the term used in the Directive for non-EU jurisdictions. A letter to the European Parliament from a group of Dutch pension plans showed that the largest plans among them place 97% of their hedge fund investments and 75% of their private equity fund investments with “third country” funds and fund managers.
These European investments in third-party funds channel private capital into global financial markets. This capital provides credit to companies and consumers as well as countries that rely on sovereign debt markets to finance public expenditures. Investment fund managers and other service providers located in the EU earn fees from providing services to international investors in Cayman funds, supporting jobs and generating taxable revenues in EU Member States.
But it is not the plight of hedge fund managers or the fear of another credit crunch that worries the Dutch pension plans: it is the plight of the pensioners for whom they are managing retirement assets. The Dutch warn that the Directive could lead to an “undue reduction of investment opportunities, higher costs and lower returns for investors.” They estimate that the Directive could lead to an annual net loss of nearly EUR 1.5 billion in investment returns and force them to raise pension contributions by 6%.
Why – at a time of financial hardship, depressed consumer spending and yawning pension and public sector liabilities – would the EU Commission force the Directive onto a vulnerable global economy? One possible reason is a desire to regulate alternative investment funds, which are often unfairly blamed for financial market volatility. Another possible reason is general scepticism of non-EU regulatory regimes.
In the spirit of openness, the Directive includes language on how third countries can establish equivalency of their regulatory oversight. In theory, equivalence would allow non-EU funds and fund managers to market themselves to EU investors. But current equivalency proposals set nearly unattainable standards for even the best international funds. Many fund strategies, such as emerging market funds and funds of hedge funds, would become virtually inaccessible to EU investors.
A better approach would be to base equivalency on standards set by the International Organization of Securities Commissions (IOSCO), which has scrutinized regulatory regimes worldwide for compliance with best practices for securities regulation. This approach would keep the European markets open to global funds and fund managers while also setting an internationally consistent standard.
Mario Draghi, chairman of the Financial Stability Board, a global regulatory body that handles G-20 initiatives, recently warned Brussels of the risk “that countries and regions will go their own way, and that the (financial) system will fragment, with very significant global costs.”
Many “third country” funds already meet high international standards. Funds that we advise in the Cayman Islands comply with a legal regime reviewed by IOSCO, the International Monetary Fund and the Financial Action Task Force. Cayman authorities share tax information and cooperate with regulators in many other countries. The IMF recently praised Cayman for having a regulatory framework for investment funds that is consistent with top international standards. It is this body of international due diligence that the European Parliament should take into consideration when weighing equivalency standards.
If a “third country” fund is unable to comply with all the components of the Directive and is not granted an EU-wide marketing passport, then a way forward might simply be to continue to allow European investors to access “third country” investment funds through individual Member State private placement regimes. European investors could then choose to invest in investment funds on the basis of the quality of the product and service providers and not on the basis of geographical criteria, as envisaged by the original proposed Directive.
The international investment community would support effective and proportionate regulations that address systemic risks. But regulation should preserve investors’ freedom of choice for the benefit of European and global financial markets and the generations of European pensioners that they serve.
Encouragingly, this appears to have been recognised and is reflected in counter-proposals to the Commission’s draft. But much work remains undone. Without proper amendments, the Directive could have painful consequences for investors and the global economy.
Henry Smith is Global Managing Partner of Maples and Calder, an international law firm based in the Cayman Islands, home to 70 percent of the world’s hedge funds.
