Speech by Dan Waters, Director, Conduct Risk, and Asset Management Sector Leader,
Euromoney AIFM Directive conference
25 February 2010
Good morning ladies and gentlemen. Thank you for your invitation to speak this morning. I have been asked to evaluate the prospects for the UK and European alternative investment fund managers’ market under the new Alternative Investment Fund Managers Directive (the directive).
You have already heard a summary of the main components of the directive from the first two speakers and you will hear more detail on some of its more important and more controversial requirements over the course of the next two days.
I will not therefore cover the detail of directive’s provisions here, but instead focus on two aspects of negotiations.
First, I will comment on some of the important changes which have been made to the directive over recent weeks in the Council of Ministers. Second, I will provide an overview of the direction of travel of the 1,700 amendments submitted by MEPs, which were debated for the first time in Parliament earlier in the week.
I want to conclude by speaking about the Hedge Fund Survey, recently published by the FSA, which summarises the work we have been doing to better understand the systemic relevance of the hedge fund sector to the financial system.
The FSA’s view on the directive
Before I turn to the negotiation of the directive in the EU Council of Ministers, I think it is important to remind ourselves briefly of the Commission’s original objectives for introducing the proposal.
These were twofold. First, in accordance with the agreement reached by the G20, to provide regulators with the ability to identify, monitor and, where necessary, address potential systemic issues arising from the activities of alternative investment fund managers (AIFM). Second, to provide appropriate protection to investors, in the context of the universal passporting regime for alternative investment funds (AIFs) and AIFMs, proposed by the Commission.
As you hear more from me and the other speakers at this conference over the next two days, I think it is important not to lose sight of what the original proposal was trying to achieve. We must continue to ask whether the directive will be able to meet those objectives.
It is also worth stating again, as we so often have, that the FSA, as the regulator of around 80% of the hedge fund management industry and 60% of the private equity industry in Europe, has welcomed the creation of a harmonised framework of sensible regulatory standards across Europe for AIFMs.
We have long supported the creation of a marketing passport for fund managers to sell across Europe under a single authorisation, which would replace the current patchwork of national private placement regimes. In creating such a passport, and through it the possibility of a new cross-border European market, sensible investor protection measures are appropriate. Consistent with the findings of The Turner Review, we also supported the proposal to allow supervisors the power to collect relevant, systemically important information from AIFMs.
While we have supported the benefits of the directive, there were significant problems with the initial draft, which have been well-ventilated and which I will not repeat here. So significant were our concerns that we commissioned Charles River Associates (CRA) to carry out an independent impact assessment of the key proposals in the original draft of the directive, which disclosed significant negative impacts on investor returns, including for pension funds and other institutional investors, through a combination of reduced access to best in class funds and large, unjustified implementation costs for a variety of fund models.
EU council negotiations on the directive
So where are we now? Nearly a year from the initial proposal, we are on our third Presidency of the Council of Ministers, and the changes to the directive just keep on coming. It is worth emphasising that, in our view, important progress on many issues was made during the Czech and particularly the Swedish Presidencies.
The majority of the equivalence tests which were originally proposed alongside a passport for third country funds and fund managers were removed, consistent with the removal of the universal passport. A more considered view was taken on many technical aspects of the proposal, which were unfortunately overlooked in the haste of the initial drafting of the directive.
The Swedish Presidency successfully coordinated negotiations to reach broad agreement on a number of issues. These improved the proposal by removing those transactions entered into at the investor’s own initiative from the definition of marketing, by providing greater clarity in the determination of which entity is caught by the directive, and in the application of capital and organisational requirements.
Overall, there was a welcome move towards differentiation and proportionality in the directive, recognising the many different types of fund structures and practices that were captured.
At the beginning of this year, the Spanish Presidency took the helm of negotiations. Some issues that had previously been agreed in the Swedish text have been reopened, which is unwelcome. This has been accompanied by increased pressure to try to conclude the discussion in the Council by the middle of March, which would be a great deal easier had thorny issues not been revisited. Given constraints of time, I will focus my remarks on the AIFMD to the recent changes proposed in respect of so-called third country funds and fund managers.
Among the most unwelcome of the recent changes to the text are the provisions relating to the marketing in Europe of non-European funds managed in the EU, and the marketing in Europe of non-European funds managed outside the EU. The debate around requirements for so-called third-country funds and fund mangers is a debate which the Council has already had. In removing the universal passport proposed by the Commission, the compromise proposal put forward last year proposed that marketing of third-country funds by third-country fund managers and by EU fund managers would, as they are now, be subject to the national private placement regimes of Member States.
These regimes could impose any requirements the local regulator thought appropriate for their investor bases, including even banning marketing all together. Private placement regimes were preserved for the very sensible reason that, if these funds had no passport, they should not be required to meet the requirements that were being put in place for passporting EU funds. The exception to this, which we supported, was that systemic information could be gathered from EU-based fund managers of third-country funds. Indeed this information is already available to the FSA, as is clear from the Hedge Fund Survey, which I will discuss in a moment.
The version of the Council text published on 15 February contained an unwelcome new requirement in respect of the marketing in Europe of a third-country fund managed in the EU – for example, a Cayman Islands, Bermuda or US hedge fund being managed out of London – and the marketing in Europe of a third-country fund managed outside the EU. This text puts the Commission in the remarkable position of attempting to dictate to non-European regulators the terms of information-sharing arrangements they must enter into with European Member States. This would enable the Commission to dictate, for example, to the SEC and the FSA, the terms of agreement between them on the marketing by US managers in the UK on a private placement basis of funds that do not have a European passport. This offends the principle of subsidiarity. It could also run contrary to well-established principles of international cooperation between financial regulatory authorities.
In the case of non-European funds marketed in the EU by non-European fund managers (for example, a US hedge fund manager marketing their third-country funds in Europe), the recent changes impose a huge raft of detailed requirements on these funds, while not offering them the passport. As already stated, the UK has always favoured granting a passport to third country funds managed outside the EU, on terms equivalent to those applying in Europe. This was a feature of the original Commission proposal – although we considered that much of the substance of what was proposed for the EU regime itself was deeply flawed. But in principle, if a sensible European alternative investment funds regime could be put in place, we see real benefits to economic growth and development in Europe from an international passport based on equivalence to such a regime.
But an international funds passport was perhaps too ambitious a place to start and in any event that passport is gone from the current draft directive. To finish, however, with a proposal that imposes burdensome, detailed requirements on funds that have no passport, will be seen as an attempt to protect European funds from competition from legitimate funds outside the EU. In the fragile international economic environment in which we find ourselves, post one of the greatest financial crises in modern history, introducing these damaging constraints on international investment flows is surely the opposite of a sensible policy.
But that is not all. This text puts the Commission in the astonishing position of dictating to the supervisors of fund managers the information that they have to receive from the fund managers they regulate. There are very limited, if any, precedents for imposing such prescriptive preconditions on non-EU entities and their regulatory authorities in relation to cross-border marketing of financial products to institutional investors.
Despite a welcome statement of intention to the contrary in the latest text published by the Spanish Presidency today, such a level of intervention would restrict the access of institutional investors in Europe to valid investment opportunities in third countries, while delivering little real benefit to European market stability or investor protection. We note that many EU investors (for example, Dutch pension funds) have already publicly aired their views on such a restriction. This is to say nothing of the impracticability of such an approach.
The proposals put forward last year required that these third-country centers and/or the funds domiciled there met certain standards set by international organisations such as IOSCO. This is consistent with the G20 commitment to a framework of internationally agreed standards and something we supported. A great deal of good work has been and is being undertaken by IOSCO and others in this area. It is that wider international framework that is relevant for funds and fund managers that have no European passport, not a European framework unilaterally forced upon third countries.
In addition to third-country aspects, other parts of the directive, including those in respect of the liability of depositaries, the delegation of activities outside the EU, the requirements on valuers and the rules on remuneration all remain the subject of debate. There are difficult discussions still to be had in the Council working groups on these issues, in addition to the raft of challenges coming from the Parliamentary side. Let me turn now briefly to that strand of the debate.
EU parliamentary negotiations on the directive
Negotiations in the Parliament commenced in September last year and the Rapporteur for the directive in the Economic and Monetary Affairs Committee, Jean-Paul Gauzès, published his draft report in November.
At the end of last week, around 1700 amendments tabled by MEPs in the ECON Committee, including the Rapporteur, were published. While some of these amendments duplicate each other and/or are quite similar, this is a record number of amendments for any directive in the history of the ECON Committee.
The ECON Committee held its first formal consideration of these amendments on Tuesday this week and has scheduled a second consideration in March. A similar process is underway in the Legal Affair’s committee, which has ‘competencies’ for certain areas of the directive.
We are still digesting the significant number of amendments table by MEPs in ECON, but I want to make a few observations at this stage.
On the issue of scope, some MEPs have suggested the exclusion of certain types of funds, such as listed closed-ended funds, private equity funds and those funds that are just marketed in the country in which they are authorised. Other MEPs have taken a different view and supported a limited application of the directive to those funds that are not systemically relevant. Whatever approach is eventually decided on, there does appear to be a shared view, which we welcome and is also held by the Rapporteur, of the need for proportionality and differentiation in the directive between fund managers of different sizes and types.
Turning to the depositary provisions, most MEPs who submitted amendments called for increased flexibility and differentiation in the requirements. There is an acknowledgement that the depositary model does not sit well with all types of fund, including private equity models, and strong support for permitting a wider range of institutions to be depositaries and permitting delegation to sub-custodians in third countries.
On the complex and sensitive issue of depositary liability, there is also strong support for an alignment to the UCITS standards and the ability for liability to be passed to sub-custodians under certain conditions. We are supportive of the pragmatic approach, which MEPs appear to be taking in this regard, to provide an appropriate level of investor protection without unduly constraining the choice of investors.
There has been near consensus from MEPs in a number of other areas, including removing the requirements for legally independent valuers and restricting the definition of marketing to the proactive offering or placement by fund managers, rather than also at the initiative of investors.
A number of areas in the directive have cross-market relevance to a number of different types of financial institutions and market participants. These areas include short selling and the issue of the disclosure of information by fund managers or investors when they acquire a certain degree of control in companies. There are a range of views across the spectrum from MEPs on these points, but at least some recognition, which we would support, of the need to introduce any new requirements on a horizontal basis rather than just for AIFMs.
On the contentious and divisive issue of third-country funds and fund managers, many MEPs commented that rules should not be protectionist and Mr Gauzès has expressed his view that Europe should not be a fortress. As I have already described, this is a difficult issue and there is no clear consensus emerging in Parliament yet on the best way forward.
Some MEPs have put forward proposals for private placement and a third-country passport to co-exist for a period of time, or for a passporting regime to come into effect at some point in the future. There are many detailed amendments, which have been submitted on a wide variety of issues. The Rapporteur’s role in this process will now be to construct compromise amendments from those which have been submitted and to prepare a report on which the ECON Committee is scheduled to vote in April.
Once the Council of Ministers and the Parliament have a mandate from their respective institutions on which to negotiate, they will then seek to develop a version of the directive which is amenable to all through a trialogue process with the European Commission. This will be a challenging process, as the current positions of the Commission, the Council of Ministers and the Parliament are materially different in a number of areas.
Adoption of the directive
By way of conclusion to my remarks on the directive, I want to stress that it is essential to get the framework right. We urge the Council, the Commission and the Parliament not to act in haste on these complex matters. Thoughtful and proportionate resolution of these issues is necessary to deliver a regulatory framework that enhances the stability of the financial system while encouraging sustainable economic growth and development across the EU.
Hedge funds and systemic risk
I want to turn now to the work the FSA has been doing to better understand the potential for systemic impact of the hedge fund sector on financial markets, a topic that is of particular relevance to the AIFMD debate. After all, as I outlined at the start of my speech, the genesis of the directive was an objective to identify, monitor and, where necessary, address the potential systemic issues arising from the activities of AIFMs.
The review undertaken by the FSA’s Chairman, Lord Turner, in March of last year, recommended that supervisors should have the power to gather information on all significant unregulated financial institutions including hedge funds, to allow assessment of overall system-wide risks.
Last year the FSA ran its first hedge fund survey, through which we sought to identify the type of information we would collect to enable us to undertake such an assessment. As many of you will already be aware, the FSA has for the last five years undertaken a survey of the largest investment banks in London, which act as prime brokers, finance providers and counterparties for hedge funds.
The hedge fund survey seeks to enable us to better understand:
the size of hedge funds’ ‘footprints’ in various financial markets, including measures of leverage and risk;
the scale of any asset/liability mismatch;
substantial market or asset class concentration and liquidity issues; and
credit counterparty risks between hedge funds and other market participants.
The survey covered around 50 of the top London hedge fund managers, touching over $300bn of assets across a range of investment strategies.
At the beginning of this week we published a report outlining our findings from this survey, which I commend to you. There are a number of interesting findings from our work. I will cover here which are the most significant and which are most relevant to the directive debate.
First, the survey allowed us to assess the presence of hedge funds in a number of different asset classes, both in terms of size and contribution to daily volume. We examined the idea of hedge funds’ ‘gross footprint’ – by which we mean the total value of their exposure to an asset class whether long or short and whether that exposure is gained directly or via derivatives. Notably, our sample data suggested that there were few asset classes where the aggregate ‘footprint’ of hedge funds was greater than 3% of any total market size. In European equities, for example, the sample data suggested that the gross footprint of surveyed hedge funds was only 0.9% of the value of European equity markets.
Second, the survey allowed us to examine the extent to which hedge funds have a material mismatch between their assets and liabilities. In other words, whether they are promising to provide investors with the ability to redeem their holdings faster than they can reasonably liquidate their assets. While this sort of analysis contains a degree of subjectivity, particularly in how liquid these assets would be in a stressed market, in aggregate the survey suggested that hedge funds in the sample did not have a significant asset and liability mismatch.
Third, the survey allowed us to examine the credit counterparty risks that exist between banks and hedge funds, enabling us to understand one possible transmission mechanism for systemic risk. The survey suggested that the maximum potential exposure any one bank had to a single hedge fund was less than $500m and the individual hedge fund with the largest aggregate credit exposure accounted for just over $1bn in total across the banks we surveyed. While these are large numbers, they are manageable in the context of these banks’ overall loan books and their capital requirements. We note that the credit crisis did not expose any prime broker in the UK to a material loss.
The word ‘leverage’ is often incorrectly used in respect of hedge fund as a synonym for risk. In the hedge fund survey we have deliberately avoided asking fund managers directly about what their leverage is and instead gathered the basic building blocks that might make up any assessment of risk – for example, their position sizes, both long and short – in different asset classes and the value of their cash borrowings and of borrowings via derivatives such as contracts for differences and total return swaps.
Such an approach reflects the different trading strategies and products used by hedge funds and allows us to select the most appropriate and relevant metrics to determine the extent to which funds pose regulatory risks.
This is of particular relevance to the debate in respect of whether national supervisors or indeed the new European supervisory authorities should set limits on the leverage that can be used by hedge funds, how these limits should be applied, and whether they should be temporary or permanent.
The FSA’s view on this is clear and has been set out in The Turner Review and repeated in subsequent speeches by Lord Turner. We do indeed see a macro-prudential role for supranational bodies, such as the Financial Stability Board and, at a European level, the European Systemic Risk Board, in overseeing system wide risks. We believe, however, that it is appropriate for national supervisors, who have the knowledge and the information to identify emerging issues in their local markets, to have the necessary power to deal with issues of financial stability at the individual firm level and local market.
These powers should include the ability to apply appropriate prudential regulation, including setting limits on leverage, for hedge funds or, where appropriate, other categories of investment intermediary.
As I have noted above, there is not one universal definition of leverage that applies across all investment strategies. As the local supervisor, however, we have necessary information to understand the relevant regulatory or supervisory risks that particular strategies pose and can take appropriate action to deal with these risks.
While during the crisis and at present it does not appear that any hedge fund reached a systemic level of importance, it is possible that hedge funds could evolve in future years in their scale, their leverage and their investor commitments, in a way that makes them more bank-like and more systemically important and that might require the application of a leverage limit. Because of its very nature it is not possible to predict precisely the type or point at which an emerging systemic issue might occur, which could necessitate the use of a supervisory tool such as a leverage limit. Local supervisors, who have access to sufficient information and appropriate powers to act in a proportionate and targeted manner, are best placed to make these judgements.
Conclusion
I will conclude by reiterating the importance of constructive engagement on this point and others by stakeholders of all types, including investors, in the directive debate to ensure that the final framework is right. Thank you for your attention this morning.
