The onslaught of global regulation shows no sign of abating. No sooner had managers submitted their Annex IV to European regulators as required under the EU’s Alternative Investment Fund Managers Directive (AIFMD) did the conversations among global regulators move to shadow banking, and debate as to whether fund managers, including large hedge funds, should be designated systemically important financial institutions (SIFIs).

The issue is a global one. The Financial Stability Oversight Council (FSOC), the regulatory body created under Dodd Frank to monitor systemic risk in US capital markets, has acknowledged it is analysing whether or not to designate large asset managers as SIFIs. Large asset managers, including BlackRock, Fidelity and PIMCO, have understandably objected, claiming that they do not pose a systemic risk. MetLife, the insurance giant, is presently suing the US government over its SIFI designation, while General Electric is exiting its financial products unit, again citing the regulatory costs associated with being designated a SIFI. This does not spell good news for asset managers. While the FSOC has hinted previously it wanted to focus more on the products and activities of asset managers rather than their systemic importance, firms should not be complacent.

Meanwhile, the European Banking Authority (EBA) – a regulatory body with no jurisdiction over funds – said it was determining whether money market funds, which comprise UCITS and managers of alternative investment funds (AIFs) be designated shadow banks. Critics highlight the designation is misconstrued, and could result in credit institutions reducing their exposures to these “shadow banks.” Critics point out the EBA’s remit has been banking, and this arbitrary designation fails to appreciate the differences in the nature of the risks posed by fund managers and banks. “Since setting up our risk and regulatory reporting business we have seen more and more cases of fund managers coming to us as they struggle to understand both the regulations as well as the boundaries and approach taken by regulators. As we assist them with their regulatory filings many fund managers are concerned with what they believe is as a one-size-fits-all approach to regulation,” says John McCann, managing director at Trinity Fund Administration in Dublin.

It is not just European or US regulators but global bodies are also exploring the SIFI issue. The Financial Stability Board (FSB) and the International Organisation for Securities Commissions (IOSCO) published a second consultation which recommended a materiality threshold for SIFI designation of $100 billion in net assets for fund managers and $400 billion gross notional exposure for hedge funds. The latter will incorporate derivatives holdings and leverage into the calculations and could ensnare some of the larger managers. “One risk is that data from reports such as Annex IV or Form PF could give regulators a misplaced belief that the industry manages far more assets than it had historically assumed. Trinity has helped managers on both sides of the Atlantic file their regulatory reports. One of the biggest issues we feel is that Annex IV’s use of the gross commitment method to calculate Regulatory Assets Under Management (RAUM), which includes the notional value of derivatives and leverage, will inflate managers’ assets on the report,” says McCann.

As such, a manager might report to investors that it runs $2 billion but could report to European regulators it is running $6 billion. The Form PF submitted to the Securities and Exchange Commission (SEC) includes leverage in its calculation, which obviously inflates assets. Regulators seeing these high numbers might believe the industry is more systemically important than it actually is. At a bare minimum, the methodology behind these calculations could result in affected managers being forced to report more frequently to regulators.

The cost implications of being designated a SIFI could be ruinous for some firms. Unlike banks, hedge funds simply do not have the financial resources or infrastructure to handle the subsequent regulatory requirements they would be expected to adhere to. SIFIs could be forced to hold more capital, impose basic liquidity risk management standards, limits on liquidity risk, stress testing, living wills and limits on single counterparty credit exposures.

While such rules can be justified when applied to banks, hedge funds collectively manage just under $3 trillion globally, a number that is dwarfed by the individual balance sheets of some banks, and a very small component of the $146 trillion that is managed by funds globally. Hedge funds as a subsection of the market are very small, and the risks they pose to capital markets are limited. Detractors of the hedge fund industry routinely point out that the events at Long Term Capital Management (LTCM) demonstrate the asset class presents a systemic risk. However, it was a market response which solved the challenges of LTCM, and no taxpayer funds were used. In addition, although some fund managers and brokers failed during the financial crisis, they did not pose any material risk to their banking counterparties or the broader economy. “The market has faced enormous challenges such as the bankruptcies of Lehman Brothers and MF Global. Regulators should be addressing the underlying causesof these failures with a proportionate consideration and regulation for hedge funds,” comments one fund manager who has chosen not to be named.

Designating hedge funds and asset managers as SIFIs would be calamitous. It would risk making it cost-prohibitive for innovative managers to run their businesses, and would hamper returns for end clients. Regulation is having unintended consequences. As the regulators seek to manage systemic risk, they are increasing operating costs for fund managers. It is becoming very expensive for firms to set up a business, and this is leading to less investor choice. This is forcing investors to allocate to only a handful of managers, some of which will not offer as attractive returns. The increased regulatory costs also means higher total expense ratios for investors. Ultimately, unless managed effectively, the cost of regulation could hinder new hedge fund entrepreneurs coming into the market. This is not just bad for investors such as institutional pension funds, but society as a whole.

Charles Gubert is a research manager at Thomas Murray IDS. He is also editor of COOConnect and COO Magazine. He is also a contributing editor to Global Custodian Magazine. He was previously a journalist at Incisive Media where he worked on Hedge Funds Review and Risk Magazine. He holds a BA in History and Politics from the University of Exeter and a Masters in International Relations from Kings College London.