The future of financial regulation - Insights from a regulator
Speech by Dan Waters, FSA Asset Management Sector Leader, FSA
International Fund Forum, Monaco
24 June 2009
I am delighted to join you today and thank the conference organisers for their kind invitation to speak.
When I spoke with the conference organisers quite a few months ago, we agreed on a very broad topic for my remarks: the future of financial regulation. This was a deliberate choice, given that the regulatory landscape was in a state of flux and it was impossible to predict where we might have got to by June. In the event, we Europeans find ourselves presented with a sweeping new Directive on Alternative Investment Fund Managers and the closing stages of a lengthy and sometimes contentious debate on the reform of the UCITS framework. These important developments are being played out against a backdrop of significant reform of European regulatory institutions and wider efforts to establish a global regulatory framework that will ensure that the severe financial and economic problems of the last two years are not repeated. I will focus my remarks on these important European regulatory developments, keeping firmly in mind, however, the fact that the European fund management industry is an essential component of a global financial system, whose soundness and success is crucial to the continued flow of international capital to underpin economic growth and development across the globe. In tackling the undoubtedly serious concerns about investor protection and financial stability that have arisen in the crisis, it is essential for governments and regulators to seek solutions that are coherent and robust at a global level and do not create or invite new opportunities for arbitrage around regulatory standards.
The Developing European Regulatory Framework for Fund Management
The European regulatory framework is evolving quickly, with the Commission moving to implement many of the recommendations in Jacques de Larosière’s report, although with some important modifications recently agreed by the heads of government. That framework will see the beginning of a move to a more centralised and uniform setting of standards across European financial markets, a move that the UK government and the FSA have supported. While we are not convinced that the sectoral approach embedded in the existing Level 3 Committee structure is the most effective and efficient structure for European financial regulation in the long term, we recognise the tactical advantages of being able, relatively easily to strengthen the functions and powers of those Committees through the creation of the new authorities that the de Larosière report suggested. So we are working with our European colleagues and the Commission to ensure that sensible and effective reform is brought about in a timely manner.
There is not yet a clear vision of a long-term European financial regulatory framework. Getting that right will require detailed analysis from first principles and should not be rushed or unduly constrained by political expediency. Ultimately, we consider that an independent regulatory standard setter, fully publicly accountable, subject to transparent and fair procedural constraints including sound and realistic market impact analysis, and protected from clandestine political interference is necessary if Europe is to have a credible regulatory framework that will protect consumers, underpin open and fair financial markets and ensure financial stability.
Asset Management and the Current Financial Crisis
The emerging changes to the European regulatory framework are set in the context of a global response to the current market crisis. The causes of that crisis are complex and deep-rooted. I commend to you if you have not already read it the report produced by the FSA’s Chairman Lord Turner on the causes of the crisis and his views on what should be done to address them. It is clear that radical changes are needed in banking regulation, not just at national or European level but right across the globe.
But less clear is what regulatory changes may be implied or required from the role played by the asset management industry in the crisis. The asset management industry is diverse and its role in the crisis is not straightforward. Certainly all parts of the sector have been massively impacted by the crisis, with very substantial declines in funds under management in the downturn years in the traditional sectors of the market and in aggregate levels of investment in hedge funds and private equity funds during this period. Consumer flight from equity to cash and other investments believed to be relatively secure has occurred, against a backdrop of profound anxiety about the soundness of major banking institutions worldwide.
Parts of the asset management industry – not least the hedge fund sector, have been singled out by some commentators as an underlying cause or perhaps a contributing factor to the current crisis. Hedge funds were subject to increasing political and academic scrutiny before the emergence of the crisis, with concerns centered around their use of leverage (particularly given the well-remembered failure of Long Term Capital Management) and the opacity of their trading strategies, leading to worries about their ability to move markets and cause disruptions due to concentrated and crowded trading. Concerns were also voiced about potential abusive market practices such as driving down the prices of financial stocks through aggressive, self-interested short selling.
As the market crisis began to unfold, hedge funds were in many cases dramatically impacted, with many closing, albeit in an orderly fashion. Orderly closure has been the general rule, even in the case of the sudden reversal of fortune at Amaranth. The evidence, however, that hedge funds were themselves at the heart of the financial crisis is sparse. We concur with the view expressed by Jacques de Larosière that the hedge fund industry did not play a major role in the emergence of the crisis. The deleveraging of these funds, however, may have played a non-trivial role in exacerbating financial instability during the crisis - but note that this deleveraging occurred at a time when the major banks, which generally operated with far higher levels of leverage, were taking similar action. We nonetheless consider it important, as Lord Turner’s report makes clear, that regulators have information about the trading of hedge funds, sufficient for them to take a view of the potential systemic impact of any fund or cluster of hedge funds on the wider financial markets or particularly vulnerable sectors of the market. The question of precisely what regulators ought to do in respect of mitigating potential risks caused by hedge funds is a crucial one. Let me turn to that now, in the context of the wider discussion about the new European draft Directive on Alternative Investment Fund Managers.
Responding to the Crisis: the Alternative Investment Fund Managers Directive
The Alternative Investment Fund Managers draft Directive is one of a package of measures put forward by the European Commission in response to the crisis. The first thing to say is that there is much in the Directive that the UK supports. We have long thought that a pan-European regime for private placement was desirable, replacing the current patchwork of regulation across the EU, which is complex and inefficient. European capital markets and the wider economy would benefit from sensible and proportionate harmonisation of standards in this area.
Regulators could also benefit from a more harmonised framework for the collection and sharing of systemically important information for the purposes of assessing and mitigating risks to financial stability.
There is a case too for the regulation across Europe of managers of hedge funds. The FSA has regulated hedge fund managers since its inception more than ten years ago. Some four years ago we set up a specialist supervision team to focus explicitly on hedge fund managers, and began gathering comprehensive data from the prime brokerage community that lends to them, giving us a good grip on their levels of leverage - which in recent years - including the run up to the crisis – have very typically been modest, especially in comparison to banks. So we are entirely convinced of the necessity for robust regulation of hedge fund managers.
So there seems to be a case for a strengthening of regulation at European level. But, as de Larosière has acknowledged, it is important that any changes accurately identify and proportionately address the major sources of weakness in the present arrangements. In a febrile environment where competing political agendas are omnipresent, there is a significant risk of ill-considered and disproportionate regulatory intervention, which in the long run will damage European markets and European investors.
It is sobering to compare the process adopted by the Commission for the production of this Directive to that followed by the Commission in the revision of the UCITS Directive. The latter has taken so far about 5 years and is just reaching final formulation. Probably too long, but the changes made have been widely debated, the impacts on markets and participants clearly understood and a broad consensus achieved on nearly all the key elements of the emerging UCITS IV Directive. The Commission engaged in extensive consultation with all interested parties throughout this period, in an open and transparent process that allowed clear airing of competing views.
The process followed for the AIFM Directive could hardly be more different. Perhaps out of necessity, it was produced under extraordinary time pressure. This has yielded a Directive whose scope and content are a surprise and in many cases a complete shock to the markets that are affected. The impact analysis, performed at a high level on the back of early general thoughts, could not possibly have addressed the myriad detailed impacts of the sweeping scope of this Directive. Indeed many of the impacts are not yet known. We urge the Commission, therefore, to listen hard to affected stakeholders as the debate around the Directive proceeds. The absence of public fora in Brussels to debate this Directive, an extraordinary thing in itself, means that views must be gathered and provided through Member States to the Council and Parliament and to the Commission staff direct.
It is important for the future of open, competitive and successful European capital markets that we get the detail of this Directive right. Ambiguity and drafting issues can and should be resolved during the EU Council processes which are taking place at the moment. What is important now, as the Directive works its way through the co-decision procedure, is the outcomes that are delivered. These should be based on delivering clear regulatory objectives and proportionate burdens on those affected by it which are justified by robust market failure and consumer protection analysis. Let me turn now to a few of the key substantive elements of the proposed Directive, starting first with its scope.
Scope
Originally anticipated by many commentators to be a hedge fund directive, the proposal presented by the Commission at the end of April is far more wide-ranging – covering the management and administration of nearly all non-harmonised investment funds (i.e. those not caught by the UCITS regime).
Subject to de-minimis exemptions of €100mn (or €500mn where funds are not levered and have five year initial lock-up periods) the Directive will cover hedge funds, private equity funds, commodity funds and real estate funds to name just a few.
If the Directive’s objective – having in mind the global consensus reached by the G20 - is to capture those funds which pose significant risks to financial stability and market efficiency, at least two important questions arise. First, is the threshold set at an appropriate level to deliver commensurate benefits to the assessment and mitigation of systemic risk compared to the costs this will impose on funds and ultimately investors? We do not consider that the present thresholds strike the correct balance between imposing additional costs and enabling regulators to identify and therefore mitigate systemic risks. Secondly, is it appropriate to create an un-level playing field for sectors of the market such as private equity whose natural competitors (e.g. family offices and sovereign wealth funds) do not appear to have been captured? We do not consider such anomalies to be sustainable in the long term.
As well as the core activities of managing and administering investment funds, the Directive also addresses tax reporting, portfolio company disclosure, employee protection and short selling. It strikes us as highly unusual to say the least to tackle issues with general market applicability through a directive targeted at the funds industry alone. The opportunities for arbitrage to avoid these aspects of the directive seem obvious and should be avoided. If we need a directive on tax treatment of financial investments, then let us have one, rather than picking off subsectors of the financial industry without regard to the wider implications.
Leverage
One aspect of the Directive which has sparked significant debate from the hedge fund industry has been the proposal to provide the European Commission and national regulators with the ability to impose hard limits on the level of leverage alternative investment fund managers can employ. There are problems at the outset with any single approach to the idea of “leverage” because of the many ways in which leverage can be measured depending on the particular strategy. It is a common misperception that higher leverage necessarily means higher risk. There are circumstances in which increasing notional exposure (a traditional interpretation of “leverage”) can actually reduce risk.
As was highlighted in Lord Turner’s report and indeed in the G20’s communiqué, regulators should have the ability to take measures to address risks that threaten the stability of the financial system. The availability of leverage limits is an important lever in a regulator’s toolkit to maintain financial stability alongside capital, liquidity and risk management requirements. The use of leverage limits, however, must be prudent and proportionate to the risk it is seeking to mitigate. During the financial crisis, the leverage in most hedge fund strategies was substantially less than the leverage in many banks during the same period. Also, of course, the assets of hedge funds are segregated from the manager and hence do not present a balance sheet threat.
We would be very worried that concern about leverage from a systemic point of view might morph into a desire to design prescriptive product regulation across the board for hedge funds. In the UCITS III Directive there are significant constraints on leverage. It does not seem to us that this approach is appropriate for hedge funds, which are not generally marketed to the retail public – indeed in many European countries such marketing is banned – and which moreover very often display volatility of returns far lower than more traditional funds on offer in the market.
Clarity about the purposes of leverage limits is paramount if we are to avoid gratuitous and destructive intervention in hedge fund management strategies, unjustified by any evidence of systemic risk, market disruption or consumer detriment. The history of national legislation in various countries in Europe is littered with failed attempts to impose regulatory design principles on hedge fund and fund of hedge fund strategies. The end result is more often destruction of legitimate and profitable investment opportunities for institutional and sophisticated investors than the prevention of any significant threat to financial stability or consumer protection.
Depositaries
The Directive proposes to impose organisational requirements on depositaries and a higher standard of liability than that imposed by the UCITS Directive. It is suggested that depositaries will need to be credit institutions authorised in accordance with the Capital Requirements Directive and will only be permitted to delegate to other depositaries. Their liability would also be increased to require them to make good losses resulting from their failure to perform their duties (whether justifiable or not), including where these losses have occurred through delegation.
These are major changes with a number of damaging and unjustified consequences. First, the number of institutions providing depositary services is likely to reduce either because the economics drive consolidation or existing providers are reluctant or not able to assume higher levels of liability.
Secondly, depositaries are likely to become increasingly reluctant to assume liability by delegating outside of their own group, therefore restricting investment opportunities for alternative investment funds and their investors in areas such as emerging markets, for example. Restraints on investor choice are certainly an undesirable unintended consequence of this particular provision.
Third, the imposition of strict liability will sharply increase costs, which will be passed on directly to fund investors. In a low interest rate investment environment, this will have a materially damaging affect on long-term investment and savings for consumers, both retail and institutional.
We are well aware of the concerns that have arisen regarding the custody of assets in the calamitous Madoff affair. It is not yet clear whether those UCITS funds which suffered significant losses were damaged by failures of their depositaries to comply with the UCITS requirements in respect of delegation by depositaries. Evidence has not been produced to show that the requirements of the UCITS III Directive on delegation of custody were in fact inadequate. These requirements do not amount to strict liability: instead, the standard for liability is unjustifiable failure.
We consider, nonetheless, that there could be benefits from strengthening the duties of depositaries through additional guidance which would elaborate the due diligence duties of depositaries in undertaking delegation of custody. Work is already underway in CESR in this regard in respect of UCITS funds and we consider that the Directive should build on the best practice due diligence of depositaries which has already been demonstrated and which could be captured in the Directive. This in our view is far preferable to the costly and potentially anti-competitive proposals in the Directive on this matter. So this article in particular needs to be reviewed in quite some detail. It is clear that in its current form it will have major cost and investor choice implications which we must not impose on depositaries and investors unless there is an unanswerable case to do so.
Transparency
The Directive mandates the information alternative investment fund managers provide at the point of sale and on a periodic basis to investors. Disclosures to investors are broadly aligned with the good practice standards already adopted by many hedge fund managers, with the most notable addition being that the identity of investors receiving preferential treatment, for instance through side letters, will need to be disclosed.
While these disclosure requirements will therefore not be a step change for the hedge fund community, this is not the case for other sectors of the market such as private equity. These requirements will also have significant cost implications for smaller funds which are less likely to be of systemic relevance/importance. The one-size fits all approach to disclosure needs significant readjustment to capture information that is useful for regulators.
The Directive also mandates the reports provided on a periodic basis from managers to their home regulators. Lord Turner acknowledged in his review (as did the G20) that the crisis has demonstrated the need for regulators to better understand the effects of all potentially systemic entities on the financial system. The review also highlighted the legal, structural and political barriers which regulators currently face in undertaking an accurate assessment of the risks.
The Directive seeks to address these barriers by requiring regulators to collect a significant volume information from all affected firms, which could be costly and also create a false sense of security for investors.
It is important that regulators collect a consistent set of information from those firms which are of systemic relevance/importance and that an appropriate framework of information sharing is in place. But deluging regulators with huge volumes of information about insignificant funds would be counterproductive, costly and contribute nothing to improving our understanding and ability to tackle effectively emerging systemic issues.
Harmonisation with other Directives
There is a long-standing perception that large sections of the asset management industry, particularly hedge funds, are unregulated or lightly regulated. In reality the industry, like other like other financial sectors in Europe, is subject to an array of Directives including the MIFID, UCITS, CRD and Transparency and Prospectus Directives to name just a few.
As I outlined earlier, there are sound reasons why changes should be made regulation in some sectors of the alternative investment industry and as I have just discussed, the Commission’s proposal seeks to introduce a range of requirements aimed at delivering these.
In introducing these additional regulations, however, the Commission should, wherever appropriate, look to harmonise these with existing requirements to reduce the cost to both regulators and firms, both of which ultimately fall to investors to pay for.
The Commission should continue to exercise a degree of caution to avoid creating an un-level playing field between different sectors of the market.
Third Country Aspects
Perhaps one of the most significant changes proposed by the Directive, is the requirement for the jurisdictions of managers based outside of the EU to meet certain equivalence tests, for instance in respect of prudential regulation and supervision, before these managers are allowed to market alternative investment funds to EU investors.
Similar equivalence tests in respect of tax accords are also imposed by the Directive on non-EU fund domiciles such as Cayman, Bermuda and the US, the main domiciles for hedge funds.
In respect of these so called “third country aspects” of the Directive it is entirely appropriate that investors are provided with an appropriate level of protection. However, as de Larosière acknowledges, in providing the protection of a strong and integrated European system of regulation and supervision, it “is for the benefit of all to preserve an open world economy”.
In the UK we have successfully permitted non-EU funds of various types to be marketed locally for a number of years. At the same time, we have banned the marketing of hedge funds to the retail market, while permitting them be marketed to institutional and sophisticated investors and sold on an advisory basis. To impose an outright ban on third country funds and managers would extinguish valuable, open and successful markets without justification. It would also appear protectionist and would offend the principle of subsidiarity. It would moreover invite retaliation from other global markets, which must be precisely the opposite dynamic that we would wish to create in the current febrile market circumstances.
Concluding Remarks
In conclusion, you should be in no doubt that the EU regulatory landscape for the fund management sector is going to be the subject of considerable change over the next few years. With other Directives such as that on Packaged Retail Investment Products, further change is on the horizon.
It is important that practitioners and investors continue to engage with policy makers to ensure that regulatory changes are appropriate, proportionate and most importantly deliver the right outcomes for investors and for the wider financial system. I would strongly encourage you to be part of this debate and to actively engage in developing an appropriate solution to the concerns we all face.
Thank you.