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EU Hedge Funds Distribution: European Commission report recommends improvements to EU cross-border framework

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A new report highlights current barriers to the development of hedge funds in Europe and suggests solutions to free up access for investors across the EU.

A new report highlights current barriers to the development of hedge funds in Europe and suggests solutions to free up access for investors across the EU.

The European Commission this week published three industry reports focusing respectively on retail investment funds (UCITS), hedge funds and private equity.

The report on hedge funds identifies a number of alternative approaches – which do not call for new EU legislation – to make hedge funds available to different categories of investor. It stresses the need to remove barriers to investment in hedge funds by institutional investors and to cross-border provision of essential support services to hedge fund managers.

The reports were prepared by the expert groups on investment fund market efficiency and alternative investments, and are a follow-up action to the Green Paper on the enhancement of the EU framework for investment funds and long-term savings vehicles.

AIMA welcomed the broad thrust of the ‘Report from the Alternative Investment Expert Group’ presented to the European Commission this week.

The Group confirms that the prevalent ‘light-touch’ regulatory approach has served the industry, its investors and the wider market well. Taking into account the level of expertise available across Member States and the fact that all industry participants are already effectively regulated, the Group suggests that additional regulation will sit uneasily with current business models and investment freedom and therefore would probably fail.

The report highlights the current barriers to development and suggests several solutions, especially freeing up access for investors across Member States.  Others include the removal of unnecessary and contradictory restrictions on institutional investors and recommending the passporting of expert services such as prime brokerage and fund administration. 

Commenting on the experts’ report, Florence Lombard, Executive Director of AIMA said: ‘This is a detailed and thought-provoking report that sets out how hedge funds operate in Europe among a very mixed regulatory environment, why the leadership and innovations provided by hedge funds are important to the European investment sector and how excessive regulation could damage it.

‘The Group’s findings show a need for some of the more arbitrary and unproductive national regulations to be withdrawn and allow the MiFID (Markets in Financial Instruments Directive) regulations to take much of the strain of uniform, EU-wide, investment distribution.  It highlights the inherent difficulties of trying to make hedge funds fit into the UCITS framework.

‘We are pleased that the Expert group is urging the EU authorities to approach the SEC about the issue of dual registration. AIMA has always felt it inappropriate that European hedge fund managers, already regulated by Member States, should have to register with the SEC. Recent events may, of course, mean that this is no longer required.

‘We hope the EC will recognise the need to be circumspect about introducing new legislation and will continue to support the lighter regulatory regime that allows hedge funds to make such an important contribution to the developments of the European investment management sector. We look forward to the expected EC White Paper on investment funds in the Autumn.’

The Expert Group’s report includes 11 recommendations shown below, summarised by AIMA:

Recommendation 1: Member States should recognise the broadening investor appetite for hedge funds and related products by developing a regulatory approach that is compatible with these needs and the organisation of the hedge fund business.

The Group recommends that European authorities and supervisors allow the provision of investment services in respect of the full range of hedge funds and related products by investment firms authorised in accordance with MiFID – without imposing additional restrictions or formalities at the level of the fund, its manager or other participants in the value chain.

In particular, the Group recommends that regulators do not seek to control sales and distribution through product regulation or registration. The Group is of the view that regulators should focus, instead, on two levels of protection:

First, the Group recommends that conditions be introduced to prevent access to hedge funds by investors for whom such investments are not suitable. A majority of Group members considered a minimum threshold of EUR 50,000 would satisfy this condition. A substantial minority considered that a higher threshold and/or other safeguards should apply;

Second, the Group recommends the enforcing of clear conduct of business requirements on the intermediaries and institutions who conclude sales contracts with end-investors. This is an appropriate and efficient means of providing the graduated level of protections required by different investor categories.

Recommendation 2: The majority of the Group recommends against reopening negotiations on the key provisions of the UCITS Directive with a view to facilitating the authorisation of a broad range of funds of hedge funds as UCITS. A minority considered that the time was right to broaden investment rules and other provisions of the UCITS directive to allow funds of hedge funds to be authorised as UCITS compliant funds.

Recommendation 3: The Group recognises the potential value in allowing retail investor access to hedge fund based investing by authorising UCITS to invest in derivatives on hedge fund indices. However, the majority of the Group recognises the validity of concerns regarding the reliability and functioning of hedge fund indices. The Group, with exception of one member, recommends that UCITS investment in derivatives based on such indices be deferred until concerns regarding the structure and performance of hedge fund indices are resolved.

Recommendation 4:
Whilst concerned about the limitations associated with product regulation, the Group recommends that the European institutions and national authorities take all non-legislative steps needed to give effect to the mutual recognition of (nationally regulated) retail-oriented hedge fund products. These should be mutually recognised as suitable for sale to the investing retail public across the European market and for distribution under MiFID conditions. This should not be considered as a substitute for other reforms suggested with regards to improving the distribution regime for non-retail oriented funds.

Recommendation 5: Regulators and industry bodies should remove absolute or arbitrary quantitative restrictions on hedge fund based investing which are imposed on some institutional investors. The Group advocates removal of any arbitrary and/or regulatory prohibition or restriction. The "prudent man" principle which informs the Directive on the activities and supervision of institutions for occupational retirement provision (IORP) should be more broadly applied.

Recommendation 6: The Group recommends that effective steps be taken to ensure a measured and appropriate implementation of the Capital Requirements Directive – one which does not result in exaggerated and prohibitive restrictions on bank investment in hedge funds. The European Commission and Committee of European Banking Supervisors should, at an early stage of the implementation of the Basle II framework, compare and reconcile the trading book rules in each Member State as well as how they are construed and applied by the competent supervisory authorities. Guidance is particularly needed in respect of the level of transparency that regulators should require when allowing banks a more favourable ‘look-through approach’.

In addition, the Group recommends that the European Commission provide for appropriate provisioning requirements under its forthcoming proposals for Solvency II. The forthcoming draft Directive should not impose excessively onerous reserve requirements which would represent an unjustified deterrent to investment in hedge funds by life-insurers.

Recommendation 7: The Group urges the European Union and national authorities to enter into negotiations with the US Securities & Exchange Commission and other relevant parties with a view to securing exemption from the US registration requirements for European hedge fund managers who are already registered with a Member State authority and are doing business with US qualified investors. If new regulations are put in place due to the US Court of Appeals decision, the Group urges the European Union Commission to make appropriate comments and to enter into negotiations so that the final regulations that are put in place do not have adverse consequences for the European Hedge Fund industry and to specifically ensure that no dual registration is required for managers already regulated in Member States.

Recommendation 8:
An absolute requirement for a local entity to perform custody functions for European hedge funds does not significantly increase the level of investor protection available above that required by such sophisticated hedge fund investors; in reality it restricts the ability of managers to generate returns which in turn impedes the ability of the European hedge fund industry to grow and compete in the global market place. Such requirements also prevent the provision of cross border services by custodians in other Member States and stifle competition.

Member State regulators should not impose a requirement for the appointment of a domestic custodian upon European hedge funds. The Group recommends that the provider of custody services to a European hedge fund should be a regulated provider of custody services, either domestically or in another Member State together with a minimum assets requirement.

Recommendation 9: Custodians and prime brokers are established in highly regulated European jurisdictions and are subject to detailed rules governing the provision of custody services. The Group supports a requirement that custodians, whether appointed solely as custodians or as part of a prime brokerage mandate, should be obliged to act reasonably and take due care and skill in monitoring the sub-custodian.

In addition to the requirement that a custodian be regulated in a Member State, the Group would support the use of a minimum assets test by Member States. This would mean that a regulated firm that is appointed as a custodian to a European hedge fund would be subject to a minimum assets test and/or a requirement that the custodian or its ultimate parent hold a specified credit rating.

The Group recommends that Member State regulators and the Commission should seek to reduce regulatory discrepancies in this respect, especially in light of the intended harmonising effect of MiFID, with particular regard to the sections dealing with custody of client assets and the prohibitions against "gold-plating" the Level II provisions in domestic implementing legislation.

Recommendation 10: Re-hypothecation limits are a critical economic variable contributing to the cost and price of providing the prime brokerage service. Prime brokers are established in highly regulated Member States and are subject to detailed rules governing the provision of regulated services.

The Group recommends that neither Member States nor the Commission impose any regulatory restrictions upon re-hypothecation limits for European hedge funds and that such matters be regarded as commercial terms of business to be negotiated between the fund and the prime broker. Any right of re-hypothecation should, however, be transparent to investors through the medium of disclosure in the fund offering documents. The Group would support any requirement, either at Member State or Community level, that a right of re-hypothecation be coupled with an enforceable set-off clause in the brokerage documentation.

However, if a ceiling is considered necessary and supervisors insist on imposing some limit for investor protection reasons through further banking/prudential rules, then it is appropriate:

to measure that limit by reference to the level of indebtedness rather than by reference to the NAV of the fund. A prime broker can determine on any day how much the fund owes it but it cannot easily track the NAV because calculating this requires more information than is available to each prime broker, especially as most large funds now have more than one prime broker;

to couple limitation on re-hypothecation with close-out netting provisions which would enable the setting off of the prime broker’s redelivery obligation against the fund’s liabilities to the prime broker; and

to ensure that each Member State recognises that a prime broker regulated in another Member State is entitled to provide prime brokerage services (for example, custody, clearing, stock and cash lending, and research) to hedge funds regulated within its territory.

Recommendation 11: As regards asset valuation, considering the global nature of hedge fund operation and the active participation of most Member State regulators in the IOSCO Standing Committee n° 5, the Group does not wish to pre-empt the IOSCO report and make specific recommendations at this time. Nevertheless, the Group is hopeful that IOSCO will not recommend the need for direct regulation or legislation in respect of hedge fund valuation and that it will advocate a system of best practice that relies upon industry led codes of conduct and permits different levels of independence in relation to the valuation function coupled with transparency for investors through full disclosure, thus allowing hedge fund investors to take the level of independence of the valuation function as well as the methodology into account as part of the due-diligence prior to investing.

The full text of the report can be accessed at

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