In July, the Financial Times reported European prime brokers were reeling in the leverage and loans granted to offshore hedge funds, and you can bet that somewhere, U.K. regulatory boss Callum McCarthy was smiling. After all, it’s been his contention that you regulate offshore hedge funds by keeping a tight reign on domestic prime brokers and fund managers.
With roughly 80% of the E.U.’s hedge funds managed out of London, you could say that the policies of McCarthy’s Financial Services Authority (FSA) are the policies of the Continent, with regulators in other member states looking to the FSA for guidance on how to implement directives coming out of Brussels. William Yonge, a London-based regulatory and funds partner with international law firm McDermott Will & Emery, says that, contrary to popular belief, the FSA’s coverage isn’t so much “regulation light” as it is targeted and risk-based.
“The FSA, in contrast to the United State’s SEC, regulates asset managers, of which hedge fund managers are a sub-set, regardless of the number of clients,” he says. “In the U.S., on the other hand, you have this bizarre scenario where potentially an investment advisor can manage up to 14 different hedge fund clients without requiring registration with SEC.”
The FSA monitors broker capital and conducts periodic surveys of prime brokers to keep abreast of positions being taken by hedge funds. It also keeps a close eye on those managers most likely to introduce systemic risk. “The FSA enhanced its monitoring of the 31 largest hedge fund managers in the U.K., accounting for 50% of the hedge fund assets managed in the U.K.,” says Yonge. “They also set up a division which undertakes risk assessments and risk mitigation with the fund managers.”
In June, after the G-8 decided not to impose tougher disclosure requirements on hedge funds, 13 of Europe’s largest hedge funds decided to be proactive by putting former bank of England deputy governor Sir Andrew Large in charge of hammering out a voluntary code of transparency — the sort of preemptive self-regulation the E.U. Commission has been promoting.
“It’s becoming more common in Europe for regulators to issue a paper and say to the industry: ‘You try to achieve a solution — perhaps produce a code of conduct, and we will look at what you think is a good way to solve these issues, if we disagree with you, perhaps we’ll bring in regulation,’” says Yonge.
And, of course, the more credible that threat of regulation, the greater the likelihood participants will offer a credible solution. A series of E.U. Commissioners, for example, have been cajoling the clearing houses to break down their barriers voluntarily or face government intervention for over a decade, but it wasn’t until this past July that the Federation of European Securities Exchanges (FESE) and the European Central Securities Depositories Association (ECSDA) in July finally announced a set of guidelines to promote interoperability among the various clearing and settlement houses of Europe.
“Key risks,” shows a list of possible problems attributed to hedge funds laid out by FSA boss Callum McCarthy. Retailization, once seen as a risk, is no longer seen as an evil — under proper supervision — based on the latest iteration of the E.U.’s Undertakings for Collective Investment in Transferable Securities (UCITS) directives covering mutual funds.
UCITS III, currently being implemented across the European Union, allows the use of derivatives in retail mutual funds. “You can now produce a mutual fund which employs hedge fund techniques and yet can be sold to the public in the U.K. and E.U.-wide without restriction,” says Yonge.
The FSA has gone a step further, creating a regime in the U.K. for a non-UCITS fund of hedge funds available to the public.
Yonge gives the FSA high marks for recognizing the importance of hedge funds and not demonizing them whilst identifying the risks they pose and systematically tackling each of them. FSA has forced wider disclosure of side letters; helped ease the backlog of credit derivatives transactions working with U.S. regulators and have helped managers improve their systems.
