International financial centres tackle regulatory challenges
By Craig Bridgewater, Managing Director (KPMG in Bermuda), Neale Jehan, Partner (KPMG in the Channel Islands) and Andrew Schofield, Director (KPMG in the Cayman Islands) – International financial centres play an important role in enabling the efficient flow of capital across borders, allowing hedge funds, in-particular, to attract investment capital globally.
The challenge for international financial centres
Historically the relatively light regulation of hedge funds has been viewed as one of the key features that facilitate these flows of capital, providing additional depth and liquidity to capital markets. Following the financial crisis, the global regulatory environment has evolved at an exponential pace, and international financial centres and hedge funds face a crisis of identity as they grapple with how to maintain relevance in this new regulatory paradigm.
The slew of legislation that has been enacted since the financial crisis, in many instances without the benefit of industry consultation and vetting, has raised the level of regulatory complexity to unprecedented levels. The US’s Dodd Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”) serves as a case in point; it was passed into law in July 2010 and requiring the creation of 398 rules* as well as various industry studies and reports. Three years on, in July 2013, 14,000 pages of regulations have been produced but only 41% of the rules have been finalised and the majority of deadlines set out in the Act have been missed.
Much of the regulatory change is extra-jurisdictional in nature, meaning that it affects not just domestic market participants but also foreign entities, such as offshore domiciled hedge funds, that operate in the domestic economy. The US Foreign Account Tax Compliance Act (“FATCA”) is an example of where the burden of compliance has shifted significantly from US taxpayers and the IRS to non-US financial institutions including hedge funds. FATCA places the burden of responsibility on non-US financial institutions to report to the IRS in respect of any US clients, with the threat of onerous withholding tax on gross payments (i.e. not just income). Similar to Dodd Frank, deadlines set out in the original FATCA legislation have had to be pushed back due to the complexity of implementation.
To complicate matters, national regulators have acted independently of each-other, resulting in inconsistent regulatory compliance requirements between jurisdictions. The UK is pursuing FATCA like regulations and Europe has implemented the Alternative Investment Fund Managers Directive (“AIFMD”) to regulate hedge funds while in the US the registration requirements for hedge fund managers has been expanded; all of which present their own significant compliance burdens.
Similar challenges face both international financial centres and hedge funds in view of the changing regulatory environment; how to comply with multiple complex and logistically challenging on-shore regulatory changes that are continually evolving while not adversely impacting performance. The complexity of the issue is evident when considering AIFMD, where in addition to a completely new regulatory framework at the EU level, individual Member States can overlap additional rules, such as the differing requirements for private placements, each creating unique logistical challenges.
Given some of the popular misconceptions around international financial centres, the response to regulatory change may surprise many.
International financial centres such as the Cayman Islands, Bermuda and the Channel Islands have actively engaged with onshore regulators, demonstrating an ongoing commitment to compliance in a rapidly evolving market. These jurisdictions have made significant investment in legislative and regulatory frameworks, negotiating intergovernmental agreements (“IGA’s”) with the IRS to meet FATCA requirements and entering into memorandums of understanding with securities regulators in individual EU member states as well as tax information exchange agreements (“TIEA’s”) to meet the requirements of the AIFMD.
This continued commitment to cooperation and the ongoing dialogue with regulators will ensure that these international financial centres remain among the vanguard of jurisdictions committed to regulatory compliance.
The outlook for international financial centres and hedge funds appears bright; international financial centres have demonstrated their commitment to compliance and have implemented increasingly robust and sophisticated regulatory frameworks.
Myths such as the potential adverse impact on international financial centres of increased tax transparency have been dispelled and the performance and growth of alternative investments through the financial crisis and beyond have increased the institutional focus on the asset class.
Source: Cayman Islands Monetary Authority, October 2013
An examination of growth in the number of regulated funds domiciled in the Cayman Islands provides some insight into the future of the industry. After almost half a decade of flat or negative growth as poorer performing funds were unwound following the financial crisis, the last two years have shown significant growth as new funds continually launch and the scope of regulation has expanded to include previously unregulated master funds. These new funds are launching into an environment where regulatory complexity is the norm and weaker funds have been eliminated following the financial crisis through a Darwinian selection process.
While it can be expected that regulatory requirements will continue to evolve into the future, it should also be expected that international financial centres will continue to adapt to these changes and efficiently facilitate the transfer of capital across borders. Similarly, hedge funds will continue to adapt to regulatory change, relying on increasingly sophisticated service providers that can leverage technology and economies of scale to provide cost effective regulatory compliance solutions.
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