Dermot Butler, President, Custom House Group

2014 – The regulatory quagmire continues

Tue, 28/01/2014 - 16:31

By Dermot Butler, President, Custom House Group – In a weak moment I agreed to a request to write this paper, giving my predictions on the hedge fund space in 2014.  Anyone who is prepared to predict the future must either be very wise and knowledgeable (not me for sure), very lucky (which I have been over the years) or most likely, stupidly arrogant, (probably stupid but I hope not arrogant).  However, having agreed, I had no choice but to sit down, pick up my pen and collect my thoughts, concentrating on the administration sector.

Before I could focus on hedge fund administration over the next 12 months I had to try and work out what the global economy was going to do over the same period and how that would translate into overall market activity.  Then I needed to decide how I expected specific market sectors would behave and the knock-on effect that would have on hedge fund administration. 
 
But that is not all: the main influence on hedge fund administration over the past five years or so, since the 2008 financial debacle, has been the huge global influx of regulation that has hit all financial services.  But from my point of view I am particularly concerned with the effect on the alternative investment markets, including hedge funds.  Many thousands – probably millions – of words have been written about these regulations, which reflects the quantity, as much as it reflects the effect (and the effectiveness – which is not the same thing) of these regulations.  It is on record that these regulations, some of which I list below, have and will continue to cost the industry hundreds of millions, indeed billions of dollars, both with regard to initial as well as on-going compliance costs.  These regulations, introduced since 2008 and which directly affects alternative investment fund managers, their funds and the fund’s administrators include, inter alia:

  1. in the US: Dodd-Frank; FATCA; the Volker Rules and both new SEC and CFTC registration and reporting rules;
  2. in Europe: AIFMD; EMIR; MIFID II; UCITS IV & V; Revised AML regulation; and the UK bribery legislation (which has been described as the most Draconian piece of UK legislation for centuries);
  3. In addition new regulations have been introduced in most active financial jurisdictions varying from the Cayman Islands to Singapore and Switzerland, which has perhaps become as Draconian as the EU.

My simple point is that the growth in the regulation and the compliance industry over the past few years is going to continue throughout 2014, including the implementation of both new and existing regulations. And this will affect administrators because managers have become reliant on administrators providing the vast selection of reports which managers (and funds) need to meet today’s reporting requirements to investors and regulators and on an increasingly regular basis.  This means administrators have to process huge quantities of data not just to produce accurate and timely NAVs, which they still have to do, often on a daily basis, but also a huge range of other reports.  And managers are getting more demanding in this regard.  That will continue through 2014.  Having said that, which is frankly a risk free prediction, I am going to move on to the more interesting and more dangerous area of prediction – namely the markets.
 
Although there has been little comment on this topic in the past few weeks, Valentine’s Day is possibly going to be one of the more intrical date in the global economic calendar in 2014, because, although an almost deafening silence has reigned over the past several weeks, that is the date that the “can” labelled “The US Debt Ceiling” is scheduled to stop being kicked further down the road.  Common sense, a rarer commodity in Washington than water in the Sahara, would suggest that, after the debacle in November last year, the Legislators in Washington would find a suitable compromise.  I suppose that it will inevitably again come down to brinkmanship over Obamacare – but I get the impression that the man in the street – the voter – is getting fed up with such games and that must be more damaging to the Republicans than the Democrats, with the election on the horizon.  So I guess the problem, which has the potential to be very damaging to the US, may be a damp squib and just end up as a blip in the history books. 
 
Taking a more direct look at the markets I am a little confused by the current attitude re inflation.  For as long as I can remember inflation has been one of several gorillas in the room and was a gorilla that everyone, and, especially, Europe’s self elected leaders in Bonn and Berlin would have been happy to bury.  Even quite recently governments were encouraged to get inflation down to below 2% and were often castigated for failing by the pundits in the media.  However, the UK has recently broken down to 2% for the first time in 4 years; the US is 1.5%, well below the Federal Reserve’s target and the Eurozone was bobbing along at 0.7% in December, which is 65% below the ECBs target of just under 2%.  The fear is that there is a real possibility, if not probability, that further declines in inflation could lead to mild deflation.  This could have fairly draconian effect on some economies.  Mrs Christine Lagarde, Managing Director of the IMF said recently that falling prices are “The Ogre that must be fought decisively”.  Her fear is that inflation in any of the rich (?) countries of the West could result in a prolonged period of deflation such as that suffered by Japan over the past 20 years or so – albeit, thanks to Abenomics, they are now beginning to see some inflation.
 
One could expect falling prices to be welcomed by the man in the street who has seen no wage inflation for several years, although that potential consumer demand could be offset by those same men in the street and commercial consumers, holding back from buying anything in the hope/expectation that it will be cheaper tomorrow.
 
And then there are interest rates and the expectation that rates will rise in the US as, or if, tapering continues.  This may bring inflation with it and encourage investment, if the investor is convinced that the US really is on a roll.  In my opinion the only way the US (and any other heavily indebted nation), can hope to dig its way out of its debt hole is by using inflation to devalue their currencies.  There are rumbles that Mr Carney may raise the UK’s rates, but the likelihood that the Eurozone will follow the US and the UK is not a foregone conclusion – so what can one predict for the markets?  And of course if interest rates in over indebted countries rise faster than growth then the overhanging debt will just increase ad infinitum, until inflation or default comes into play.
 
Also there is a growing fear that equities are a growing bubble, as is property – but rising equity and real estate markets are inevitable if there is nothing else to invest in and there is a huge amount of money sloshing around that must be invested somewhere.  It was reported in the FT this week (22 Jan) that Apple, Microsoft, Google, Verizon and Samsung have aggregate cash balances equivalent to the GDP of the United Arab Emirates in 2013.  Furthermore total cash holdings of about one third of the world’s biggest non-financial groups amounts to about US$2.8 trillion. If they would start to invest that the whole picture will change.
 
But can we expect a change of heart from the Multi-National Misers? I doubt it in 2014.

So far I have mostly side stepped predicting anything – other than the inevitable fact that administrators will have to invest to provide their clients with a full modern administration service, which today includes not just efficient accounting and accurate shareholder services but also providing assistance with regulatory compliance – which is of course also an opportunity.
 
And of course there will be a surprise or two which will make life in 2014 more interesting.

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