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Pragmatic regulation is the way forward

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Amid what is perhaps the most extensive re-writing of the global financial rulebook ever undertaken, the alternative investment industry  – like the rest of the global financial sector – 

Amid what is perhaps the most extensive re-writing of the global financial rulebook ever undertaken, the alternative investment industry  – like the rest of the global financial sector –  is expecting additional regulation as well as other potential challenges.

The ongoing financial crisis has led to calls for reform of the regulatory system around the world, including additional regulation for hedge funds, private equity firms and other financial institutions.

The focus of this new regulation is no longer on the safety of individual investors, as was previously the case, but rather on financial stability, safety and soundness. New regulations are expected in several interrelated areas, including new registration, reporting, disclosure and prudential requirements for individual funds, fund firms or individual managers. In addition, hedge funds will likely have to confidentially report, either directly or through counterparties, data relevant to systemic risk monitoring.

Some hedge funds – either due to their size or their particularly important role in certain market segments – could also be designated as ‘systemically significant,’ making them subject to direct regulation.

Of course, hedge fund regulation is a question of degree. Some market commentators, notably in continental European countries in which hedge funds are domiciled, have called for hedge funds to be tightly regulated, along the lines of banks or retail funds. By this view, regulation should set out what hedge funds can and cannot do, as we all explore the nature and scale of their leverage and the obligation to render their strategies transparent to other market participants.

In the United States, initial bills emerging in Congress seek to require hedge funds, venture capital firms and private equity firms to register with the Securities and Exchange Commission (SEC), under either the Investment Company Act or the Investment Advisers Act. These proposals have been considered in the past. For example, the SEC adopted a rule in 2004 that required hedge funds to register as investment advisors, but the US Court of Appeals for the District of Columbia vacated that rule in 2006. Nevertheless, similar proposals have moved up the legislative agenda.

Regardless of where in the world one looks, additional regulation is just around the corner and hedge funds are already taking measures to restructure, retrofit their processes and optimise their administration to be ready for market recovery and a future landscape composed of fewer, larger hedge funds and new regulatory requirements.

The financial crisis has also driven them to renew their efforts aimed at both cost efficiencies and improved risk management. For example, hedge fund managers are examining their various risk monitoring techniques and stress-testing their portfolio models through worst-case scenarios. Hedge funds are also increasingly engaging third-party administrators and independent portfolio valuation services to address the concerns of their investors, regulators, central banks and finance ministries.

But much depends on what regulatory measures are deployed. Surely, if governments undertook a precipitous round of regulation, including requiring information to be provided on investment strategies, the future of the hedge fund industry could be at risk. Applying bank-like capital rules or mutual fund-like investment restrictions to hedge funds puts the vital role that hedge funds play in financial markets in jeopardy. Such regulations would also risk reducing market diversity to the detriment of both individual and institutional investors.

In Europe, the hedge fund industry is already regulated to a great extent. While European fund vehicles are frequently established in offshore jurisdictions, primarily for asset gathering purposes, fund managers are for the most part located onshore and concentrated in jurisdictions such as the UK, where they are regulated and supervised by the Financial Services Authority.

In addition, hedge fund trading in Europe falls under existing EU rules such as the Market Abuse Directive, which places those activities within regulatory reach. Hedge fund trading activities are also rendered transparent by the transaction reporting requirements of the Markets in Financial Instruments Directive (MiFID), which requires that detailed information be supplied to regulators on a trade-by-trade basis. The introduction of the EU-wide Transaction Reporting Exchange Mechanism (TREM) should provide regulators with much of the information they require.

Having already successfully navigated through all of these regulations, European managers should be able to compete with the rest of the world under a new, stricter regime, just as well as –  if not better – than they did prior to the crisis. Needless to say, all eyes will be on the decision of the European Parliament and member states.

Whatever new architecture emerges from the community of global regulators, market forces are already well underway that will lend greater transparency and security to hedge fund administration and operations. A stable, sustainable hedge fund industry would benefit from administrative innovation, including independent pricing and avoidance of counterparty pricing whenever possible; the standardised reporting of price/performance measures; segregation of safekeeping functions; independent fund administration; and, the exclusive use of regulated entities to provide such key services as administration, safekeeping and prime brokerage.

Jack Klinck, executive vice president and global head of State Street’s Alternative Investments Solutions team

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