Global Outlook 2024 Report

Newsletter

Like this article?

Sign up to our free newsletter

Rewriting the rules: Key issues shaping the compliance landscape

Related Topics

As hedge funds’ compliance teams get to grips with a byzantine array of plans from market authorities on both sides of the Atlantic, wider economic and political developments are continuing to recalibrate the investment and regulatory environment.

As hedge funds’ compliance teams get to grips with a byzantine array of plans from market authorities on both sides of the Atlantic, wider economic and political developments are continuing to recalibrate the investment and regulatory environment.

ESG

As environmental, social and governance (ESG) trends have gathered momentum within the financial services and investment management sectors over the past decade, the EU has led the charge globally in setting the benchmark for sustainable investing guidelines, predominantly through its far-reaching Sustainable Finance Disclosure Regulation (SFDR).

Introduced in March last year, the SFDR – which applies to a wide range of financial firms, advisers and products, including hedge funds – sets out a formalised framework to report sustainability risk factors, with affected firms required to either ‘comply-or-explain’ how they will or won’t integrate ESG considerations into their business and investment processes. Further Level 2 requirements, which take effect in January 2023, will add mandatory principle adverse impact statements and other disclosures relating to environmental-linked valuation risks.

With hedge funds increasingly building ESG and responsible investing into their portfolios, the SFDR is now high on the industry agenda in Europe. Around one in four hedge fund managers globally are concerned by the regulations, according to Hedgeweek’s survey. Among European hedge fund firms, that number soars to over two-thirds, with 68% of managers either ‘very’ or ‘somewhat’ concerned, against 32% who are not concerned.

“Europe is not going to be alone in its efforts as the UK and other jurisdictions look to define their takes on ‘avoiding harm’ and ‘doing good’ in terms of economic activities and entity-level conduct,” says My-Linh Ngo, head of ESG investment at BlueBay Asset Management.

“With ESG data and ratings increasingly emphasised as the basis for firms evidencing their credentials, the quality, reliability and comparability of these mean providers will also come under greater scrutiny this year.”

Across the Atlantic, in May this year the Securities and Exchange Commission set out wide-ranging plans for increased disclosures for ESG-focused investment funds, aimed at providing more detailed information on funds’ and advisers’ incorporation of ESG factors to help bolster transparency for investors. The measures include specific disclosures in fund prospectuses, annual reports, and adviser brochures based on the ESG strategies they pursue.

The proposals follow on the heels of SEC plans for mandatory climate disclosures for US corporates, with factors such as greenhouse gas emissions included in audited financial statements, and the establishment of a dedicated Climate and ESG Task Force in the Division of Enforcement at the US regulator.

Hedge fund industry experts note how most managers – except for certain quantitative and high-frequency-type traders – have been evaluating ESG factors as a risk mitigation tool for some time, in advance of the SEC’s new measures.

“I think that the upshot is going to be that managers are going to need to be thoughtful about their stance on ESG, and having a policy that reflects what they’re doing and that they are clearly disclosing it to investors, and that everything is consistent across the various disclosures in term of fund documents, investor meetings, pitch book, Form ADV,” says Nicholas Miller, partner, Seward & Kissel.

“The key point is that there is a strong system to document their process on ESG, and to really back up that they are doing what they are telling people they are doing regarding ESG.”

Digital assets

With cryptocurrencies experiencing ongoing volatility shocks this year, the ways in which the evolving digital asset space can be brought under closer regulatory scrutiny by market authorities globally has emerged as an increasingly live issue.

Regulation continues to be the number one obstacle in preventing managers from launching a digital assets hedge fund strategy. A Hedgeweek survey conducted in January found close to a third of managers placed regulatory and compliance complexity surrounding crypto ahead of key challenges relating to custody risk, investor appetite and launch cost/complexity when it comes to rolling out a digital assets-focused fund.

Industry participants note how crypto and digital assets are becoming increasingly interlinked with regulated markets, with regulators increasing pressing for more disclosure in order to avoid blow-ups, which can potentially have greater knock-on effects to broader markets. Given the perceived lack of transparency in the market, SEC chair Gary Gensler has pushed for tougher oversight of digital assets, with a view to regulating them in line with traditional securities.

“The SEC has taken a broad view as to what would be considered a security – a lot of this goes towards the perception that an advisor to a private fund which trades digital assets may take the view that they are not securities, and their fund is not an investment company, and they can avoid significant amount of securities-based regulation.

“This is a constantly-changing situation. Where it looks like we’re heading with the SEC is that there’s going to be a very expansive view of categorising digital assets as securities. This is going to be a key point for digital asset managers.”

Meanwhile, the EU has unveiled new bloc-wide Markets in Crypto-Assets (MiCA) regulations, aimed at replacing the patchwork and fragmented nature of current guidance. The new rules, set out in early July, include authorisations for crypto-asset service providers and tougher measures to ensure investor protection.

Gary Pitts, founder and managing partner, Tetractys Partners, says: “NFT funds, funds of crypto funds are starting to emerge, while exchange traded products appear to be the quickest way to get to market if you want to do something in crypto – you set up the SPV, you become the issuer and have the basket of securities, so your credit risk is less of a concern if you have a segregated basket. Again, with some of the blow-ups recently, where things appear to be pegged to the dollar but still manage to go to zero, one questions whether these underpinning baskets will be effective.”

Brexit

The UK’s withdrawal from the European Union continues to loom large over the European hedge fund industry, owing to London’s traditional dominance – in terms of asset volume – of the sector on this side of the Atlantic.

With far-reaching reviews of AIFMD and MiFID/R ongoing, the extent to which the UK’s Financial Conduct Authority diverges from established EU frameworks remains a key area of focus for managers.

According to Hedgeweek’s survey of hedge fund managers, more than a third (36%) of UK and Europe-based respondents said they remain either ‘very concerned’ or ‘somewhat concerned’ about the continued fallout from Brexit. In comparison, 64% of managers in the region said they were not concerned.

As a result of the UK’s withdrawal from the European Union, the volume of hedge fund industry assets across the European Economic Area’s 30 member states has tumbled from €354 billion in 2019 to just €89 billion in 2022, according to the European Securities and Markets Authority’s Annual Statistical Report on EU Alternative Investment Funds.

ESMA’s report, which was published earlier this year, said: “In terms of size and composition of the AIF sector, Brexit had its largest impact on hedge funds.

“HFs managed by UK AIFMs accounted for more than 75% of the NAV of UK and EEA30 HFs and more than 97% of AuM. Since UK HFs tend to be larger and use more leverage than EEA30 AIFs, leverage measures have declined when comparing EEA30 data for 2020 with the 2019 data published in the previous report (which included the UK in the EU),” ESMA observed.

Linda Gibson, director, head of regulatory change at BNY Mellon | Pershing, said in a recent market commentary: “We now have two regulators moving in different directions and with different priorities which will have a significant impact on firms who need to be able to integrate the amendments into their wider business strategy and look out for more amendments to be announced as they are drip fed through.”


Key Takeaways

  • As the EU has taken the lead on formalising rules on ESG, two-thirds of European hedge fund firms are concerned about the potential challenges brought about by the bloc’s SFDR.
     
  • Both the SEC and ESMA are moving towards tightening up oversight of digital assets markets against a backdrop of soaring cryptocurrency volatility, as Hedgeweek research shows regulation continues to be the number one obstacle in preventing managers from launching a digital assets hedge fund strategy
     
  • The dominance of London-based managers within the European hedge fund industry meant the UK’s withdrawal from the EU has had a substantial impact on asset volumes among European AIFs 

Like this article? Sign up to our free newsletter

Most Popular

Further Reading

Featured