This time last year, the European Union, with the exception of Germany, was drifting towards the “light touch” model of hedge fund oversight advocated by the United Kingdom’s Financial Services Authority (FSA). Retail providers across the Continent were gingerly introducing currency derivatives into investment funds, albeit only for hedging purposes, because that’s all that’s permitted under the Continent’s amended directives covering Undertakings for Collective Investment in Transferable Securities or UCITS.
These are European investment funds that meet standards of transparency, structure, and practice agreed upon by all EU member states and can be ‘passported’ into all member states without having to be approved by the local regulator.
European futures funds and hedge funds, on the other hand, must be structured as private placements and approved by each state in turn. Likewise, managed futures accounts can be marketed across the European Union when the minimum is €50,000, on the assumption that people who can afford them have deep enough pockets to absorb the risk.
Before the subprime mortgage debacle, European regulators were talking of letting managed futures into pension schemes – and many still are, but their utterances have become background noise in the debate over the operational side of the over-the-counter (OTC) hedge fund industry, triggered after several small European banks went into receivership after finding themselves the shamed owners of bad American mortgage debt. Now even the FSA says sloppy controls by hedge fund operators put the system at risk.
With the bulk of European hedge funds domiciled offshore but distributed through London-regulated entities (see: “Location, location,” below), the FSA has impacted more hedge funds than has any other regulator, and for a while most Continental regulators were following their lead.
In late 2006, for example, the EU Commission’s Alternative Investments Experts Group (AIEG) had joined the global Counterparty Risk Management Policy Group (CRMPG) in declaring the hedge fund menace overblown. Both hailed the counterparty checks and balances developed under the auspices of the International Swaps and Derivatives Association (ISDA), as well as the FSA’s light touch approach.
And as for the charge that hedge funds were abusing their ownership privileges by kicking around corporate managers, the decidedly un-hedge-fund-friendly European Parliament issued the following statement:
“Corporate managers are learning to value and exploit the feedback and strategic advice they receive from hedge fund managers; they rate the business acumen of hedge fund managers more highly than the classic (and often passive) institutional ‘long-only’ investor.”
But critics like German Chancellor Angela Merkel and her finance minister, Peer Steinbrück, never bought into any of the arguments. Both conceded that the UK approach was a necessary component in the protection of unsophisticated retail investors, but they warned that it left the door open to systemic risk, while Steinbrück remained openly skeptical of their short-term motives as owners.
Both were pilloried by foes of overregulation, who zeroed in on Steinbrück’s call for all hedge funds to be required to register their positions with the European Central Bank (ECB) – but Steinbrück himself has stated that such a step would only come about if the industry doesn’t get its own house in order. All he’s ever really said in absolute terms is that hedge funds should be forced to come up with a sort of National Futures Association (NFA) of hedge funds: a structured and transparent (if informal) self-regulatory entity answerable to European Union regulators.
But you can’t really say the German view has been vindicated. The Bundesbank, for example, was right in warning of systemic risk related to the proliferation of credit default swaps, but their prescribed remedy was a call for hedge funds to be audited by ratings agencies – the same group now being investigated by U.S. and European authorities on suspicion of jacking up ratings to ensure more sales of securities.
Even if the more sinister motives of ratings agencies go unproven, it’s clear they contributed to the subprime meltdown by putting their stamp of approval on packages of bundled subprime debt.
But it’s equally clear that counterparty risk isn’t the issue in this debacle. Rather, the issue is what blinded the end buyers of the debt to the risks they were assuming. After all, these were professionals who knew that a certain amount of default was built into the bundles of debt they purchased.
HEDGE FUNDS RESPOND
In September, French President Nicolas Sarkozy joined in demanding more transparency in the OTC derivatives market. European Union finance ministers, in the form of the Economic and Financial Affairs Council (ECOFIN), concurred by announcing they were willing to work with the United States to promote hedge fund transparency and monitor “valuation processes, risk management, and liquidity stress testing.”
This has ratcheted up pressure on the Hedge Fund Working Group (HFWG), an endeavor launched in June by European hedge funds and headed by former Bank of England deputy governor Sir Andrew Large. The HFWG had already proposed in July to follow the valuation principles laid out by the International Organization of Securities Commissions (IOSCO), and in October they published a 125-page consultation paper outlining the case for self-regulation and the best way of achieving it. Basically a philosophical discourse (well worth reading, and downloadable at www.hfwg.co.uk) on the case for keeping things largely as they are, but conceding the need for disclosure on issues relating to systemic risk.
A week later, the FSA made its now infamous announcement that it was disappointed in the self-regulation of UK-based investment managers controlling offshore hedge funds.
“Every fund had at least one issue where there was room for improvement,” the FSA said in a statement posted on its Web site, adding that the awareness of what constitutes market abuse was “nonexistent” among some fund managers.
Contrary to what often has been reported, the statement hardly represented a rethinking of the FSA’s basic approach. Instead, it indicated that hard times lay ahead for managers in its jurisdiction that don’t monitor their offshore activities properly.
As in the United States, European futures funds are a long way from becoming mainstream retail products, but that hasn’t stopped behemoths like Winton Capital from amassing €10.5 billion in managed futures money under management and €4.5 billion in more esoteric products.
Still, getting that big isn’t easy, even with the impressive numbers Winton has posted. They’re up 15% this year, and consider that a catastrophe, having taken ‘hits’ of 1% in July and August before adjusting to the new trends in September and October.
That’s largely because futures funds can only be offered as non-Ucits or private placements. Managed accounts can accept investments of €50,000 or more from investors in all European Union member states, without having to go through costly registration procedures, but some member states have a lower minimum.
Last year, the AIEG recommended opening hedge funds to pension funds, insurance companies, and banks – a proposal in limbo until early 2008.
With the rise of London, Frankfurt and Paris as financial centers, it’s easy to forget that the Netherlands once ruled the world of finance – a centuries-past delusional madness into tulips aside. Even now, the Dutch pension funds have about €1 trillion under management, right behind the United Kingdom.
Former Dutch foreign minister Bernard Bot, now running a hedge fund, has called on Dutch pension funds to rally themselves in support of a Dutch investment industry in the spirit of Germany’s “Finanzplatz Deutschland” drive of the 1990s (The Dutch call theirs the “Holland Financial Centre”).
And they’re not alone. Ireland and Luxembourg have gotten their regulatory regimes up to Ucits speed, and have become centers for managed investment schemes of all stripes as well as places where hedge funds like to do business (see: “Irish Funds”).
In all the confusion, it’s easy to forget that there is no consensus definition of what a hedge fund is – as opposed to managed futures, where rules, regulations, and conventions are well-defined and transparent. From the perspective of investors, however, both take risk that is non-correlated to the stock markets and both tend to be lumped into the same category.
For Winton co-founder David Harding, that presents a marketing dilemma; one he believes the investment bankers may have solved.
“They’ve finally come up with a name I like,” he says. “After all, calling us all ‘hedge funds’ is awful, because we’re not really hedging anything, and ‘alternative investment funds’ is equally bad, because you have to ask, ‘Alternative to what?’”
He prefers the latest term du jour: ‘modern investment funds’, which works though absolute return strategies is more to the point.