Funds Hub

Money managers under the microscope

Dale Gabbert: Drive-by shooting misses regulatory target

July 15, 2009

Guest blogger Dale Gabbert heads the funds group in the London office of law firm Reed Smith. His practice covers hedge funds, private equity and property funds and he is the author of Hedge Funds, a legal guide published by Butterworths Lexis Nexis.

The views expressed here are entirely the author’s own and do not constitute Reuters’ point of view.

Rather than take a sniper’s aim at systemic risk, the draft EU Directive on Alternative Investment Fund Managers is more of an ill-conceived drive-by shooting that injures the innocent whilst leaving the intended target unharmed.

dgabbertWhilst few would dispute that radical steps need to be taken to control systemic risk, the directive is likely to cause widespread collateral damage to the financial services industry whilst failing to deliver significant regulatory benefits.

It is hard not to view the directive as simply being a wish list of grievances with no real unifying theme other than a somewhat misleading title. The document covers a dizzying array of unthematic topics ranging from fund managers through to administrators (rather mysteriously called “valuators”), custodians, the disclosure of interests in unquoted companies and the origination of structured products.

It is also largely incorrect in its central assumption that managers of hedge funds are not regulated. All hedge fund managers in the UK are regulated – they are required to be by legislation that the government brought in nearly a decade ago. Since the UK has by far the lion’s share of European hedge fund managers, the central premise of the directive that there is insufficient regulatory oversight is incorrect – they are already regulated.

Likewise, the fund’s primary service providers, the “prime brokers” are all regulated entities operating out of onshore centres.

The simple fact is that what hedge funds do and the people who do it on their behalf are regulated both because the service providers like the manager, the administrator and the prime broker are regulated and because there are a wide range of rules (such as, for example, the market abuse regime) relating to market behaviour generally which apply to hedge funds as well as other market participants.

One of the most disappointing things about the draft directive is how clearly it betrays a very poor grasp of the way funds work and the differences between them. If these are the people who are going to solve the world’s systemic risk problems, isn’t it a concern that they don’t seem to distinguish at all between hedge funds, private equity funds and property funds? These are totally different businesses with totally different sectoral risk profiles.

To show how truly unsophisticated this directive is how about this – the directive appears to regulate managers of retail funds which do not qualify as UCITs. Why? 

Whilst most of the recent press focus has been on the provisions relating to managers, leverage restrictions and the directive’s inherent protectionism, some of the most troubling features relate to more mundane service providers, such as administrators and custodians. Some of these provisions will lead to large increases in the cost of providing these services, such as the proposals that custodians will be directly liable to fund investors and that they will be strictly liable for acts or omissions of sub-custodians.

Quite apart from the fact that this will radically change the way the custody industry has organised itself, these new risks will be priced into the charges they levy and the costs will be passed on to the ultimate investors, such as pension funds, in the form of lower returns.

One can understand from a political perspective why the EU feel they have to be seen to attack hedge funds but what exactly have custodians and administrators done to merit this?

The real concern here is that a populist measure is going to end up arming regulators for the wrong war whilst hurting consumers through reduced choice and increased charges. Whether managers relocate or not is a rather unedifying side-show, the real issue is that this draft doesn’t work.

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