After the protracted debates about financial regulation, the regulatory fog is at last beginning to clear in Europe and the US. The banking crisis has resulted in a wide range of regulatory initiatives ranging from tougher capital and liquidity requirements on banks to measures aimed in Europe at the alternative asset management industry – hedge funds and private equity – in the form of the Alternative Investment Fund Managers Directive (AIFM Directive).

The priorities in the US and Europe have been rather different. In the US the focus has been much more on regulating banks than hedge funds. However the outcome will be broadly similar. The importance of banking as a source of finance will decline in the coming years while capital markets will expand and the role of sophisticated investors such as hedge funds will become more important.

Europe has come a long way over the last 18 months. The shape of the AIFM Directive has been agreed but it has been a steep learning curve for all involved. The Directive originated at a time when there was significant hostility directed at hedge funds and many wrongly attributed the crisis at least in part to the hedge fund industry.

Since then, there has been a growing awareness among European policy leaders that more sophisticated players in capital markets with the ability to take risk without causing systemic contamination are needed more than ever. It is now much better understood that hedge funds are fundamentally different from banks and therefore need a different regulatory approach. While there may still be reservations about certain aspects of the AIFM Directive, the legislation as it now stands is something the industry can live with.

Investors in particular played an important role in ensuring some of the more damaging proposals were modified. It was investor pressure, alongside three letters in which Tim Geithner, US Treasury Secretary, highlighted his concerns about protectionist elements in the Directive that helped to shape the outcome towards a more favourable result and to preserve open European capital markets.

The approach towards regulation in the US in the wake of the crisis has been different from Europe. There the focus has been on the Volcker rule, which aims to reduce risks inherent in the banking sector by curbing proprietary trading and ensuring that this type of activity is carried on outside the regulated banking sector. Interestingly, Paul Volcker has indicated that it will be necessary to rely on the well-developed US capital markets, including hedge funds, to fill the gap resulting from the reduced ability of banks to take risks. This assessment hints at a development European policy leaders have not yet fully taken on board. Higher capital and liquidity requirements for banks will make banking a more expensive source of finance and the consequence will be that Europe’s capital markets will become more important in providing investment for economic growth. This is a positive development. It means more choice for investors, more opportunities for sophisticated players such as hedge funds and, more generally, it allows risk taking without systemic contamination thereby making the financial system more resilient.

Remarkable though it may seem, the hedge fund industry, which has so often been berated by European politicians, offers a solution to the problem Europe faces as the banking industry pulls in its horns in the face of tougher regulation and capital requirements. Hedge funds can help fill the gap with their appetite for risk and ability to absorb losses and they can do all this without endangering systemically relevant banks.

However if hedge funds are to play a bigger role, it is important that they are seen to adhere to the highest standards. The laborious process of agreeing the AIFM Directive has demonstrated the difficulty of prescribing detailed regulations for an industry as diverse as the alternative investment sector and has highlighted the limitations of what regulation can ultimately achieve – particularly in terms of better protection for investors.

No one questions that regulation (and the threat of sanction by regulators) is needed in areas such as market integrity and prevention of market abuse to ensure investors can have confidence in the transparency and probity of capital markets. It is also axiomatic that in areas where strong systemic externalities arise, such as banking, regulation to prevent excessive risk taking is needed.

The case is also clear when it relates to retail investor protection, where regulation does produce superior outcomes. However, what does it mean for the institutional market space? Can investors now be less diligent because there is more regulation?

In fact, the contrary is true: in an area as complex as alternative investment and hedge funds, expert judgement is needed more than ever today to distinguish good and bad practice. This is particularly relevant in areas such as risk management and governance, where we should be under no illusion about what regulation can achieve. These are the areas where investors will need to remain fully engaged by ensuring that hedge fund managers conform to the kind of standards of good practice identified by the Hedge Fund Standards Board (HFSB). No savvy investor can afford just to rely on regulation to produce better outcomes.

Therefore, despite all the efforts to meet regulatory requirements going forward, the hedge fund industry’s focus should lie on catering for what its user, the investors, care for: an industry which meets high standards and delivers good performance. The huge expectation for regulation to produce better outcomes often seems to overshadow the powerful role investors actually play in driving better standards in the hedge fund industry. After all it is ultimately the investors who can rapidly sanction underperformance and inadequate standards by withdrawing their money or not investing. Let’s not forget that there are thousands of investors out there doing this every day. This is a very powerful complement to good regulation.

That is why investors play such an important role within the HFSB in a collaborative effort with the fund managers. The HFSB, which acts as custodian of the Hedge Fund Standards, is jointly governed by leading investors and managers and the recent announcement of the HFSB Investor Chapter demonstrates how significant the investor role has become. More than 30 major hedge fund investors, including pension funds, sovereign wealth funds, funds of funds and private banks have participated and together they account for more than $130 billion of hedge fund assets under management.

Managers and investors involved with the HFSB believe that this collaborative effort is the healthiest and most productive way forward to improve outcomes. It means market participants take ownership and responsibility for their own market place and ensures that those with the best insights and understanding determine the standards and norms according to which the market should operate.

This approach also gives confidence to regulators and policymakers, thereby reducing the risk of external interference in the market place in the future. However it is important to note that this is not self regulation but a complement to regulation. It involves a collective effort by producers and users, where the users (investors) are completely aligned and have the ability to sanction those that do not perform or do not meet the standards. Ultimately, all involved benefit. Managers will
face rising demand from investors, who in turn will benefit from higher standards in the marketplace.

To consult the list of members in our Investor Chapter please go to www.hfsb.org