After the AIFMD Apocalypse

The future for the regulation of hedge funds in Europe

Originally published in the November | December 2014 issue

The first thing I need to do is to apologise for the title of this piece. I think it’s fair to say that describing the implementation of AIFMD as an apocalypse is over the top and although predicting the future can be a fool’s errand, I think that when we ask ourselves the question, “What is the future of hedge fund regulation in Europe?” the answer is fairly self-evident. There’s going to be more of it.

Although AIFMD did not prove to be the end of the hedge fund industry in Europe, the directive did represent a significant change in the way that European hedge fund managers and the distribution of alternative funds to European investors were regulated. For the first time, hedge fund managers had a regulatory regime that was designed exclusively for them – although, of course, many still question whether the regime was well designed and whether it will prove to be effective. But the latest figures I’ve seen suggest that the European hedge fund industry has approximately $461 billion under management and that that figure has grown by approximately $80 billion over the past year.

So it’s true that the European industry's share of global hedge fund assets has fallen from a peak of 25% to just under 23%, but the truth is that throughout the period of uncertainty created by AIFMD and its imperfect implementation, the European hedge fund industry has continued to gather, manage and grow assets, and despite the regulatory and wider economic environment, could broadly be said to be thriving. It is that continued success that has captured the attention of financial regulators still reeling from the financial crisis and increasingly enthusiastic about demonstrating their own ability to both predict and manage future sources of systemic risk in the global financial system.

AIFMD represented a perhaps belated recognition amongst the regulatory community of the significance of hedge funds to the financial sector and to the wider economy. Now that the industry has gained the attention of its regulators, it’s unlikely to lose it. This perhaps is the price of success. This piece will address not just the quantity of regulation, but what it’s likely to look like, and how it is likely to be enforced. I will consider a number of regulatory proposals that are in the pipeline, including the future development of AIFMD itself, developments in MiFID 2 and the revised Market Abuse Directives that will have a direct impact on the European hedge fund industry. I will also go on to speculate a little bit about regulatory developments that, although not yet proposed, I believe may well materialize.

The regulatory environment
However, I would like to start by looking at the regulatory environment in which the industry will have to operate. What do I mean by the regulatory environment? Well, I mean two things really: firstly, the complex interaction between European legislators, the European supervisory authorities and the national regulators of each member state, and secondly, the way in which those national regulators behave and enforce regulation. All of you who followed the development and implementation of AIFMD will be more familiar than you ever wanted to be with the slightly unedifying process of European legislative development. High-level political objectives are established, and level one directives, regulations and these objectives are defined in a strange tripartite dance between the European Commission, the parliament and their council of ministers. Each of these bodies has its own distinct agenda and purpose, the development of which inevitably involves a degree of horse trading between their constituent members.

Although it is of course important that this process allows the many different voices of Europeans to be heard, it means that the development of complex and technical pieces of legislation can be hindered as the various actors involved play to their own galleries and then quietly make significant and important concessions in, for example, fisheries policy in exchange for equally significant concessions in financial service legislation. Although necessary, this process leads to imperfect and sometimes internally inconsistent legislation. So the job of making level one directives and regulations make practical sense has since 2011 fallen to the three European supervisory authorities, and in our industry (the securities and the funds industry) that’s ESMA, the European Securities and Markets Authority. So ESMA is now responsible for developing level two and level three legislation.

Level two delegated acts are concerned with the substantive content of the legislative requirement – for example, defining the level of information that must be reported to national regulators by funds being marketed in their jurisdiction. Level three guidelines and recommendations are developed by ESMA with the view to establishing “consistent, efficient and effective” supervisory practices – that’s their words – by each of the 28 national regulators, and in the hope, again in their words, of achieving the “common uniform and consistent application” of European Union law. This goes hand in hand with the increased use of regulations rather than directives − the key difference being that regulations have the direct effect on market participants and do not have to go through the filtering process of being implemented into national law. So ESMA’s work in the use of regulations is a distinct step in the direction of a common European rulebook for financial services.

A welcome step
My feeling is that most industry participants welcome this in principle. There’s a great desire to be able to undertake business across Europe on the basis of a single set of rules. However, as we have seen, for example in the short selling regulation, and particularly in the implementation of AIFMD, we are still quite some way from achieving that goal. This is despite the tools that ESMA has available to it, including the ability to require national regulators and market participants to publicly explain why they have not complied with a particular set of regulations or guidelines, and ultimately to launch investigations either at its own initiative or in the initiative of a national regulator, the commission, parliament or the council, which can result in it issuing a recommendation to the defaulting national authority or even recommending that the commission refer a case against the member state to the European Court of Justice.

The reason for this I think is relatively simple. Although there is this clear move to a common European rule book, the national regulators of each member state remain responsible for implementing and enforcing regulation in Europe. Each regulator has its own priorities, its own areas of experience and expertise, its own areas of weaknesses, levels of sophistication and importantly, wildly varying budgets. It is for this reason that I think the second aspect of the regulatory environment, the way in which national regulators behave and enforce regulations, becomes so important.

By way of example, I’d like to be a little bit parochial and just talk about the conduct of the UK’s Financial Conduct Authority. Early in the course of his tenure as the chief executive of the FCA, Martin Wheatley said that he wanted the regulator to shoot first and to ask questions later. He also made clear that he is not particularly interested in legal arguments relating to the rights and wrongs of a particular rule, or how the regulator is interpreting it. This approach – I think a better word might be attitude – comes about from a desire to move away from the tick-box regulation which is generally considered to have failed in the run-up to the financial crisis, and resulted in the FSA not being as effective a conduct regulator as it should have been. The FCA has made it clear that its focus will be on outcomes rather than compliance with rules. It will not be sufficient in the FCA’s view for a firm to be able to demonstrate that it has complied with the detailed rules to which it is subject if the FCA believes that the right consumer or market outcome has not been achieved; even when there is full compliance with the rules it intends to nevertheless pursue regulatory action. We’ve seen this already, most recently in the FX cases in which the FCA accepted that there was no technical market abuse, but has fined banks on the basis that they engaged in market abuse-like behaviour that breached the principal free requirement for a firm to take reasonable care to organize and control its affairs responsibly and effectively. So there’s no comfort for hedge fund managers in thinking that this is an approach that will be applied only to banks or to firms dealing with retail consumers. Historically, the FSA considered participants in the wholesale markets sophisticated enough to look after themselves, and rarely intervened in transactions between financial institutions. This view has now changed. Following the LIBOR and FX scandals the FCA, probably rightly, argues that wholesale conduct can and does have an ultimate impact on retail customers.

Greater scrutiny than ever before
We know that pension funds and other endowments are significant sources of capital for hedge funds, so it’s difficult to argue that the behaviour and conduct of the managers does not have an impact for better or for worse on the end users of those pension schemes. So consequently the FCA has indicated that it intends to place wholesale conduct under greater scrutiny than ever before. It has said it will “increase the intensity with which we supervise wholesale conduct” to ensure that transactions between sophisticated market participants do not have a harmful impact on market integrity. We’ve seen a recent example of this approach in the FCA’s work on dealing commissions. In July the FCA issued a discussion paper, ostensibly in preparation for MiFID 2 and the increased restrictions on inducements that it contains, in which the regulator indicated that it now expects firms to unbundle all the cost of research provided by executing brokers from the cost of order execution, and that firms are required to establish the price of the research so received on an objectively justifiable basis.

Whatever the pros and cons of this particular requirement, this is an example of the FCA short-circuiting the tiresome business of making rules on which they are, for example, required to consult, by requiring firms to explain why they have not adopted the best practices that the FCA considers desirable. The FCA has given effect to its closer scrutiny of wholesale conduct through policy development, international engagement and firm-specific assessments of banks, trading firms and asset managers, and emphasized that addressing the culture and systems and controls that govern wholesale relationships is a priority area for it. Its approach is demonstrated in the various thematic reviews that it has recently undertaken, including in relation to market abuse amongst asset managers.

Conflicting messages
All of this generally praiseworthy activity has resulted in some conflicting messages from the FCA. On the one hand, the FCA has said that it wants to understand whether wider market outcomes are being achieved rather than if a firm is meeting individual rules. In other words, it’s not concerned about individual rule breaches, provided that overall a firm is behaving in a way that promotes orderly market conduct and protects market participants and investors. And to be fair, I think this has resulted in some fairly sensible and pragmatic decisions by the UK regulator. Unlike some of its continental counterparts, the FCA is not particularly inclined to enforce against a firm that has, for example, filed a short selling notification or a major shareholding notification a couple of days late, provided that there is evidence that the firm in question is taking steps to remedy the issue and that it is not part of a wider problem or systemic disregard for regulatory requirements. However at the same time, the European regulatory framework continues to produce a multitude of detailed rules with which the FCA and other national regulators expect and require firms to comply.

So the regulatory environment is complex. Hedge fund managers operating in Europe, whether they are EU AIFMs, MiFID firms operating as sub-advisers to a parent outside the Union, or simply a non-EU manager seeking to raise capital from European investors, need to understand the rules that are being created in Brussels; they need to understand how these rules are understood and implemented by the regulator in each of the European jurisdictions in which they are operating; and they need to know whether there are additional gold-plated rules in the jurisdiction that sit above or work in parallel to those European rules. Managing hedge funds is of course an international business, and there are very few European-based managers who are not also subject to laws in the US or Asian jurisdictions in which they seek to trade or to raise capital.

Regulatory moral overlay
Then on top of all of this, managers have to take into account what I think of as the regulatory moral overlay. It’s not enough for managers and their compliance officers to just consider whether they have complied with the rules: they also need to think about whether they’ve complied with the spirit of the rules and the purpose of the rules – whether they’ve complied with the rules and engaged with their customers and counterparties in a way that is consistent with regulatory principles, and which demonstrably achieves what the regulator considers from one moment to the next to be best practice.

So it’s in this context that I would like to consider some of the detailed rules and regimes that are being proposed in Europe to further regulate hedge fund managers. We have, of course, all been living and breathing AIFMD for a number of years now. Indeed, I’ve been advising clients on the directive and how it would affect their businesses since it was first proposed in 2009. In those early days there was a lot of fear. It was clear in the early drafts of the directive that its sponsors really only had the loosest of ideas as to what a hedge fund was, and the differences between hedge funds, private equity funds, the various alternative asset classes and the way in which they were operated, and, as a result could be regulated.

It was also not particularly clear in those early days as to why the legislators putting forward that directive for the hedge fund industry needed to be regulated at all. Although short sellers were an early bogeyman of the financial crisis, it was clear to most impartial observers that short selling was an early indicator of a bad bank, not the cause of its collapse. The EU’s own detailed report into the causes of the financial crisis found that, to the extent hedge funds played any part at all in creating the crisis, it was minimal and ancillary to the misunderstood build-up of risk within banks. Slowly, as the directive went through that European legislative process, it evolved from a piece of legislation that limited the types of strategy that could be run by European regulated managers (and prohibited anyone who wasn’t a European regulated manager from raising capital from European investors) into the directive that we know and love today.

Two hemispheres of regulation
I think of that directive as being divisible into two hemispheres. The first hemisphere regulates those EU managers who are located in the EU, and defines the capital that they must carry, the way in which they organise themselves, manage risk, remunerate their staff and yet still, by applying rules relating to securitizations, asset stripping and leverage, the strategies that they can pursue – albeit in a far more limited way than was first contemplated in 2009. The second hemisphere regulates the way in which funds are marketed to European investors and defines the information that is required to be provided to those investors and to the regulators of the country in which the funds are marketed.

It is still perhaps hard to discern a particular reason why the first hemisphere was necessary, or why the existing MiFID regime was not sufficient. Although it is early days, my experience suggests that most existing MiFID managers who did go through the variation of permission to become an AIFMD manager did so with little difficulty, and with little material upheaval to existing governance structures, although going through that process was time-consuming and somewhat painful in parts. I’ve also so far seen little evidence of regulatory arbitrage between jurisdictions. ESMA’s step forward to a common rulebook has been a great success in this regard, as there’s little advantage as far as I can see other, than for fiscal reasons, establishing a manager in Malta or Dublin rather than one of the more established jurisdictions.

So it’s in the second hemisphere of AIFMD, the rules relating to the marketing of funds, that we’ve seen the greatest evidence of differences in approach between regulators. One of the great hopes expressed during the creation of AIFMD, primarily by regulators, was that it would create a brand not unlike UCITS that would act as a mark of quality, and which would be actively sought out by investors in Europe, and also in other jurisdictions. Again it’s early days, but I’ve seen very little evidence of such a brand or investor appetite developing.

There are multiple reasons for this. The one most commonly expressed to me by my clients is that AIFMD creates protections for investors who don’t really want them and, possibly, don’t even need them. I think there’s probably truth in that. But the real reason, to me, is that the carrot of an AIFMD passport is not sufficiently large or juicy to encourage managers who do not need to do so to submit themselves to the AIFMD stick. Investment managers located in Europe and who did not want to radically restructure their businesses to avoid it had little choice but to become regulated as EU AIFMs. However, very few of those managers ran money in funds domiciled in Europe. As the AIFMD passport is currently available only to EU managers marketing EU-domiciled funds, most EU managers find themselves in the same boat as their non-EU competitors, and have to comply with the national private placement regimes in each of the countries in which they wish to market.

The truth is that countries that were previously easy to access for non-EU managers, such as the UK, remain relatively easy to access. The appropriate disclosures need to be made to investors and Annex IV reports need to be filed, but it’s relatively straightforward. The countries that were difficult to access, like Germany, remain difficult. These countries impose additional requirements: the depository-lite regime, with a view to creating a level playing field with local regulated managers who are required to appoint an AIFMD depository; and that additional lengthy registration process that you need to go through in Germany. But again, it’s achievable. Those countries that were always nearly impossible to access, for example Italy, remain pretty much impossible to access.

So at present EU-regulated managers have little significant competitive advantage over their non-EU counterparts. Where they believe that they have a realistic prospect of an investor in a given jurisdiction, both EU and non-EU managers will look hard at the hoops that need to be jumped through to comply with the relevant national private placement regime, and make an informed decision as to whether they want to proceed.

Reverse solicitation
There’s also of course the question of reverse solicitation. A large number of non-EU managers continue to rely on reverse solicitation as their primary means of raising European capital. It’s not unheard of for European managers to take the same approach. They do so understanding that what is meant by reverse solicitation varies greatly between countries. For some it means that there can be no prior contact between manager and investor at all. In others, a view is taken that a significant amount of information can in fact be provided to prospects before they finally request the offering memoranda and subscription documents, thus creating the reverse solicitation.

The wisdom of relying on reverse solicitation – and indeed the robustness of the mechanisms that lawyers like me have implemented to mitigate the known risks of relying on reverse solicitation – are unlikely to be severely tested until we have moved through this economic cycle into the next downturn and investors seek ways in which to recoup any losses. And it’s my view that these marketing factors will drive the development of AIFMD over the next few years. Baked into the directive were two key dates for the review and extension of the regime. Prior to July 2015, which is coming up very rapidly now, ESMA is required to deliver an opinion to the European Commission as to whether there should be an extension of the passport. Such an extension would allow EU managers to take advantage of the passport even in respect of the non-EU funds that they manage.

It would also allow non-EU managers that are prepared to comply with the requirements of the first hemisphere of AIFMD, the organizational, capital and other requirements, imposed on the existing EU managers to take advantage of the passport and to avoid the more difficult national private placement regimes. ESMA has begun its work on this area, and at the beginning of November published a call for evidence on the issue. It’s looking at the effects that the extension of the passport would have on investor protection, the monitoring of systemic risk and, in my view most significantly, the question of whether extending the passport would put the EU fund industry at a disadvantage vis-à-vis the rest of the world, taking into account financial regulation and supervision, tax, anti-money laundering rules and any general or specific difficulties which EU managers or UCITS managers encounter in establishing themselves or marketing their funds in other countries.
I do not know what the review of ESMA’s outcome will be, but it seems likely to me that with a view to increasing the attractiveness of the AIFMD regime to managers, the passport is likely to be extended. I imagine that EU managers will be permitted to market their non-EU funds, provided that the funds are domiciled in countries with which ESMA is comfortable or appropriately co-operative, and I also suspect that non-EU managers will be permitted to market their funds on a passported basis, but only to the extent that they are prepared to comply with the full spectrum of AIFMD requirements and are based in jurisdictions which allow European managers some degree of access to their investors.

I also suspect that the second timetable development for AIFMD, the suspension of the private placement regimes in 2018, will be used to shepherd as many managers as possible into the AIFMD fold. We may well see private placement regimes in many countries being tightened up as we move closer to 2018, making it more and more difficult to rely on them and to access investors in those countries without being AIFMD-compliant. I imagine there will also be adverse findings or a commentary in relation to reverse solicitation, again with a view to making it as difficult as possible to raise capital in jurisdictions without being AIFMD-compliant.

The success of this strategy will be directly correlated to the success of the European economies, and the availability of capital for investment, as it is unlikely that non-EU managers will submit themselves to European regulation unless there is a real prospect of raising money. It may also be that the greatest threat to the success of AIFMD as a regime comes from within the fold of existing European regulation. Many managers now regard the liberalized UCITS regime quite favourably with AIFMD, and it may well be that those managers for whom European capital is important increasingly seek to use the more established UCITS regime which has a degree of global recognition, and which allows them to target both retail and professional investors.

MiFID in focus
But for all of the focus on AIFMD in recent years, it is important to remember that it is not the only source of European regulation that is relevant to investment managers. The provisions of the Market Abuse Directive are relevant to anybody, wherever they may be, who is trading under a European regulated market. Many hedge fund managers operating in Europe actually operate as sub-advisers and fall outside of the scope of AIFMD, and are regulated as MiFID firms. Even for those managers that have become AIFMD firms, MiFID will continue to have relevance, as it has a number of provisions that are applicable to non-MiFID firms and will in any event affect the European markets on which they trade. Both of those directives, MiFID and market abuse, are in the process of being updated.

Revised directives and related regulations were published earlier in the year, and firms will be required to comply with the new provisions from early 2017. As we’ve discovered with AIFMD, these dates which seem so distant now tend to creep up on us very quickly. The scope of the market abuse regime will be extended to capture financial instruments which are traded on and MTFs and the new form of regulated market, the OTF, that has been created by MiFID 2, in addition to the principal European regulated markets. The offence of market manipulation will be extended to capture cross-market manipulation and in particular transactions in spot commodities which are intended to have an effect on the prices of traded financial instruments and vice versa will be prohibited.

Defining insider trading
There will also be new offences of attempted insider trading and market manipulation. The revised directive confirms that information will be regarded as having a significant effect on price if it is information a reasonable investor would be likely to use as a part of the basis of his investment decision. It also codifies decisions that have been made by the European Court of Justice – in particular, the finding that information relating to an intermediate step which is part of a protracted process may be precise information and therefore can by itself constitute insider information. This in many ways reflects recent regulatory decisions in the UK a couple of years ago, where managers finding themselves in possession of small pieces of the jigsaw, if the regulator feels that they can string those pieces of the jigsaw into an incomplete puzzle, still may be in possession of inside information even though any one of those little nuggets of information on their own isn’t sufficient to constitute inside information.

The revised directive also includes an excellent example of a rule that simply does not make much sense. The directive expressly permits banks engaged in market soundings to disclose information about a prospective securities issuance, provided that it makes and records a determination as to whether the information is inside or not, and if it decides that it is, informs the potential recipients that the information is inside and that it will be restricted if they choose to receive it. That’s fine; it sort of makes sense, except that where multiple banks are involved, they may well come to different conclusions as to the status of the information that is being disclosed.

So some managers who receive a piece of information may have had to agree with the bank to restrict themselves while others do not. Some managers may even find themselves getting the same piece of information from different sources, some having to agree to restrict themselves, others not. I imagine this is an idiosyncrasy that will be resolved by ESMA at the level two and level three stage, but it’s one of many things that are difficult to understand at this moment.

Also, with the revision of the Market Abuse Directive, one of the consistent criticisms of the Directive over the last few years has been that there has been no consistency over the level of fine sanctions that have been imposed across the Union. So for the first time the revised regime establishes a framework for civil sanctions: companies convicted of market abuse could be fined up to 15% of their annual turnover, or if greater, €15 million. Individual perpetrators could face fines of up to €5 million and a likelihood of being banned from the industry.

Day-to-day consequences
Looking at MiFID 2, it is actually tempting to think of it as being a package of minor reforms with little significance, particularly for the hedge fund industry, but in fact there are a number of provisions which, if not having quite the same profound impact as AIFMD, will nevertheless have consequences for the day-to-day operations of European hedge fund managers.

One of the most obvious developments within MiFID 2 to affect managers – or at least those who pursue quantitative or other high-frequency trading strategies – is the specific regulation for the first time of algorithmic trading. An investment firm, whether or not regulated pursuant to MiFID, engaging in algorithmic trading (which is defined in the directive to mean trading that uses computer algorithms that automatically determine the parameters of orders) will be required to have in place effective systems and risk controls to ensure that its trading systems meet a number of standards. They have to be resilient and have enough capacity subject to appropriate thresholds and limits which prevent sending erroneous orders; they have to not function in a way that contributes to a disorderly market; and they cannot be used for any purpose that is contrary to the laws of the trading venue to which it is connected.

All of those high-level objectives and standards are going to be developed into technical standards that firms are going to be required to meet through ESMA’s level three work. It’s also worth noting that there’s a cross reference to the Market Abuse Directive, and that in the level two work relating to the revised Market Abuse Directive, certain types of high-frequency trading strategy will be specified as being per se market abusive – for example, using algorithms to layer trades on a market. Those firms that engage in high-frequency trading will be required to store time sequence records of their algorithmic trading systems and the trading algorithms themselves for at least five years. ESMA has proposed that the records should contain sufficient detail to enable ongoing monitoring by national regulators and again, that is an example of the type of technical discussion that is happening between ESMA, the commission and local regulators, to really knuckle down and get detailed regulations and detailed rules with which managers will have to comply.

MiFID 2 also contains greater restrictions in the conduct of business rules. As I’ve already mentioned, it will significantly reduce the circumstances in which investment firms can accept inducements including, for example, investment research, and that is going to have a profound impact on the way that the brokerage and the hedge fund industry and market participants interact with each other. The reach and scope through MiFID 2 will also be extended. Transactions in derivatives, emissions allowances and certain commodities which all fall outside of the scope of the directive at the moment will fall within MiFID and the scope of its regulation, and that will have various implications for the way in which managers trade those assets and the markets on which those transactions are executed.

There are also various (regulators would use the word) “enhancements,” of the way in which trading securities and transactions are reported, more detailed requirements in relation to pre and post-trade transparency. I have described a regulatory environment which will be increasingly focused on wholesale market participants and which, in the UK at least, will be more interested in overall behaviour and the outcomes that result than with the compliance with individual rules. I have also given a summary description of only a few of the detailed rules that will soon apply to hedge fund managers.

Don’t forget the detail
So I suspect that the question that’s in many of your minds is: if my regulator is only concerned with outcomes, does that mean I don’t have to worry about all of these detailed rules that I’ve been boring you with? I’m afraid life is never that simple. There are not many hedge fund managers who do not operate on a cross-border basis. So managers that operate across Europe may be able to take some comfort that with the step towards a common European rulebook, the rules with which they are meant to comply will be broadly the same across the European Union. But for as long as national regulators are responsible for enforcing those rules, managers will have to take account of the ways in which they are interpreted in different countries.

Just within the terms of AIFMD this means understanding, for example, how a particular regulator defines or understands the boundaries of marketing, whether it has gold-plated its national private placement regime, whether the asset-stripping rules apply to all companies with an investee group or just the topco – just as the many other nuances of interpretation that need to be dealt with across the union. In any event, even for those managers dealing with the FCA and other regulators who take the same outcomes-based approach, ignoring the detailed rules isn’t going to be an option.

I suspect the FCA will become less and less interested in checking for itself whether a firm is technically compliant with a particular rule. Instead, I think that the FCA accepts that it simply does not have the resources to engage in intensive supervision of the many hundreds of asset managers under its direct regulation. It will increasingly require senior managers and compliance officers to personally attest to the efficacy of the firm’s systems and controls, and in its day-to-day compliance with applicable rules. Where problematic outcomes do occur – for example, the failure of an algorithmic computer system, or the systemic failure to provide correct information and regulatory disclosure – the regulator may well rely on those personal attestations to take enforcement action against the individual and the firm concerned on the basis that if the individual attested that a system was compliant and it then failed, the attestation must have been given negligently or fraudulently.

Looking to the future
As we look further into the future, I think it’s likely that the focus of bodies such as the G20 and IOSCO on systemic risk in the economic system will begin to materialize into rules that impact the hedge fund industry. In the medium term, I suspect that this will mean rules requiring greater disclosure, probably around more detailed and more public disclosure of positions held within funds, and potentially also of the beneficial owners of those funds. Over the longer term, I think that two trends will begin to emerge.

Firstly, there will be an ever-increasing degree of international co-operation between the rule-making bodies – and I don’t mean just within Europe: I mean between Europe and America and Asia and the various countries within those regions. As a result of that, there will be a greater convergence of the general principles of regulation, even if there will continue to be differences in the detailed rules. As an aside, I think it’s worth saying that although it will have a profound impact on the country asa whole, Britain’s future in or out of Europe is actually not that likely to have a particularly large difference in the way hedge funds operating here are regulated, as this is going to continue to be driven by supranational factors and bodies, although it may of course make it more difficult if we leave for UK-based managers to access continental capital.

The second trend, which I think has the potential to have a far more harmful effect on the hedge fund industry, is that there are already indications that larger funds are going to be regarded increasingly as shadow banks and regulated as such. I think that it is near certain that some of the regulatory tools that are now being used in the bank industry will be applied to larger managers. This is likely to involve closer supervision of managers on a day-to-day basis, but also has the potential to include greater intervention in the development and execution of investment strategies. This may take the form of regulatory restrictions on the type, size and quantity of investments that a fund can take, but more likely will require funds to implement complex and prescriptive risk management systems designed to prevent the positions held by funds having any systemic implications for the wider economic system. The fear will of course be that such regulation will stifle the innovation and flexibility that has made managers successful.

I opened this piece by saying that AIFMD had not in fact been an apocalypse, but that there would be more regulation. I have, I hope, given you a sense of the type and form of regulation that we’re likely to see over the short and medium term and perhaps into the longer term – in particular with regard to the evolution of AIFMD, the extension of the passport, the development of detailed rules, the Market Abuse Directive and MiFID 2. But I’ve also spoken about the environment in which those rules will be enforced, and the fact that hedge fund managers will need to take into account the detailed rules promulgated in Europe, the different ways in which those rules are implemented across the Union and, importantly, the expectation amongst regulators that market participants will comply not just with the letter of the rules but also with their spirit, as expressed by the regulators themselves. I’ve also speculated a little about the potential trends in international regulation and the possibility of funds being regulated as shadow banks.

Overall, I would say that the way in which the hedge fund industry in Europe is regulated has evolved and will evolve in a way that is consistent with the evolution of the industry itself. As hedge fund managers grow and mature as businesses they will increasingly be regulated as and expected to behave as significant financial institutions. Adapting to this while maintaining the flexibility and nimbleness that has made the industry so successful will be a challenge. So I’ll conclude by saying there was no apocalypse now, but perhaps (hopefully not) apocalypse later.