Regulation 2010 and Beyond

A world tour of hedge fund regulation

Originally published in the January 2010 issue

It wasn’t long ago that a hedge fund manager in London could be up to date on regulation and compliance by mastering a couple of slim Securities and Futures Association ring-binders, which would be occasionally updated, and skimming a few monthly board notices. These memories of the 1990s seem like a distant dream.

Today’s counterpart wishing to master the regulatory inbox has a very different proposition. SFA has become the Financial Services Authority and the rule book is considerably longer, while the manuals and postal updates have been replaced by the web with digitalisation aiding digestion.

So far so good, but keeping on top of what might change has become considerably harder – it is necessary to keep any eye on European developments by looking at the European Commission website ( except that probably will not show the views of the European parliament on changes to directives so better add in that website (, too. European legislative initiatives might not appear on either of these two but instead on the website of the current president of the EU ( or indeed of the next president ( Naturally there will be few helpful links between these sites – one just has to know where to look.

But hold on, these European sites may only discuss issues at a high level, so in order to get to the detail of current consultations on key topics, we had better also check the committees that advise the Commission. For securities and markets issues, this would be the Committee of European Securities Regulators ( and, if our interest is banking related, the Committee of European Bank Supervisors ( or for insurance and pensions issues, the Committee for European Insurance and Occupational Pensions Supervisors (

Boning up on your national and European rules is still not enough. Our hedge fund manager should also check on global organisations, because the regulatory agenda is increasingly driven by international considerations following the 2007/8 credit crisis. Since the April 2009 G20 meeting, the centrepiece of the new world order has been the Financial Stability Board (FSB) ( which has been set up by the G20 and other international financial institutions. FSB’s report to the G20 summit in September shows that it has a core role to monitor the progress in achieving the goals of the London Summit – see Box 1 (below). FSB is tasked to look for “vulnerabilities” in the financial system and co-ordinate the standard-setting process (regulatory capital, compliance, accounting, conduct of business) of its members. FSB has to marry up macro-prudential issues and the micro-prudential risk.

It is not advisable to stop at the FSB. Its high level agenda is set by the G20 so should be checked too. More technical issues are discussed by other stakeholders of the FSB including:

• The Bank for International Settlements (BIS) (, which has several committees including: Basel Committee on Banking Supervision (bank regulatory capital), Committee on the Global Financial System (sources of stress in the global financial system) and the Committee on Payment and Settlement Systems (settlement systems for cash/securities);
• International Association of Insurance Supervisors (IAIS) (;
• International Accounting Standards Board (IASB) (; and
• International Organisation of Securities Regulators (IOSCO) ( IOSCO is increasingly setting global standards for investment management and the regulation of securities trading (see, for example, the IOSCO principles and the memoranda of understanding on exchange of information between regulatory bodies).

Can one stop there? No – issues common to the banking, securities and insurance industries, including the regulation of international conglomerates, are also considered by the Joint Forum which was established under the aegis of the Basel Committee. It has a web page there with its list of influential publications.

To be fair, some of these organisations and committees have existed for years but the 2007/8 financial crisis has increased their interaction and industry. National governments wish to stop arbitrage within the regulated world, (eg. between banking and insurance), and between the regulated and unregulated parts (i.e. hedge/private equity funds) of the financial system. Therefore a hedge fund manager needs to track the range of regulatory output from securities trading to banking. There is almost universal consensus that the revised regulatory framework should apply internationally to avoid some nations having a competitive disadvantage. Two memorable phrases from the crisis illustrate aspects of this problem – the first attributed to Mervyn King that ‘banks live globally but die nationally’, and the second, from the Turner Review, that ‘the UK needs either more Europe or less Europe’.

There is a tension between the desire to create a sufficiently powerful body to issue and enforce rules over different nations or states and ensuring democratic accountability. The EU and the US, the two largest regional holders of financial assets in the world, have both encountered difficulty. The US has a complex network of state and federal agencies split across banking, insurance and securities. Individual states would be unwilling to cede power to a single federal regulator which would in any case, given the size of the US market, be too powerful for Congress.

The EU, which is perhaps the closest experiment to a mini-world government by treaty, has spent 15 years trying to achieve varying degrees of harmonization at significant cost. Neither jurisdiction was able to prevent the collapse of institutions, such as Landesbanki and Lehman, with all of the painful fallout about the competence of different national regulators, the depths of different deposit protection schemes and global treasury arrangements in bankruptcy.

To the chagrin of hedge fund managers, these examples are about the banking model whilst hedge funds seem to have come through the crisis without being found culpable. But all financial businesses have become tarred with the same brush and the balance of the intellectual debate has irrevocably shifted from Anglo-Saxon ‘light touch’ regulation to a more continental-style distrust of ‘financial locusts’. The result has been the draft Directive on Alternative Investment Fund Managers which has been categorised by the industry alongside the UK Dangerous Dogs Act, 1991. This proposes a regime for: hedge fund (which are not UCITS compliant) marketing within Europe by EU and non-EU managers, investor transparency, custody, monitoring (if not limitations) on leverage, principles of remuneration and rules on independent valuation. The majority of these are sensible for European-wide rules (especially since Madoff) which should help the industry gain investor confidence. Unfortunately, the political desire to create quick legislation has meant that the draft Directive comes across as protectionist and attempting to limit legitimate hedge fund trading. This has not been helped by a lack of engagement by the current UK government with the initiation of European legislation and the opaque process whereby draft directives are amended seemingly by backroom deals. The result is a complete lack of trust between the industry, UK government and the European lawmakers which is viewed as having significant powers to regulate the (crucial) details of the industry without public scrutiny. The appointment of Michel Barnier as the new internal markets commissioner, responsible for the single financial market, has added some spice to the situation together with some unhelpful remarks from President Nicolas Sarkozy.
The overall message of this sorry saga is that the alternative fund management business, which grew out of the proprietary trading desks of the investment banks, needs to complete the process by further distancing itself in the public’s mind from bankers and banking excesses. This is important because the structural problems with banks, arising from the implicit government guarantee and their “too big to fail” status, could take a generation to solve. In contrast, there is nothing wrong with the basic hedge fund model.

Indeed, following the process of financial dis-intermediation of the last 25 years, it has become a core part of the financial system which does not need fiscal support. Hedge fund managers should allow themselves to become part of conventional fund management as their strategies converge. This will provide them with the best political protection.

So what about our notional hedge fund manager – can he or she finally be considered up to date? Probably not. The impending general election in the UK could see a Tory government elected with plans to abolish the FSA, merge it into the Bank of England and set up a separate consumer protection authority. There will thus be many more websites required to set out these plans as well as the plans of their European and international counterparts.

Box 1:
London Summit, 2 April 2009

• Creation of Financial Stability Board

• International Co-operation: establish supervisory colleges for large cross-border firms, implement principles for cross-border crisis management, cross-border bank resolution arrangements, Early Warning Exercise

• Prudential Regulation: increase regulatory capital when recovery is assured, better quality capital, mitigation of pro-cyclicality, leverage constraint in banks, risk management of securitisation, Basel II to be adopted by G20, stronger liquidity management supervision

• Scope of Regulation: amend regulatory system to allow macro-prudential risks to be identified in banks, shadow banks and private pools of capital; large financial institutions to be supervised carefully; increased data collection, prevention of regulatory arbitrage, hedge fund managers to be registered; reform of credit derivatives market

• Compensation: Endorsement of FSB principles whereby compensation to reflect risk and time horizon

• Tax havens and non-co-operative jurisdictions: counter measures to protect tax base and prevent money laundering

• Accounting Standards: improve standards for valuing financial instruments based on liquidity, address pro-cyclicality, work towards a single global accounting standard

• Credit Rating Agencies: to be regulated consistent with IOSCO Code of Conduct