Offshore hedge funds put EU regulation in doubt

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The Spanish EU Presidency is aiming to close an agreement on the draft hedge and private equity funds directive at a meeting of finance ministers in Brussels tomorrow (16 March), with teething problems on foreign fund treatment threatening to derail a deal. 

The UK is pushing for EU-wide recognition of hedge funds that have won approval on its territory.

But such an agreement appears unattainable at the moment as Britain and France continue to hold opposing views on the proposed Alternative Investment Fund Managers Directive (AIFMD).

Britain wants a single EU "passport" for hedge funds but France does not, summarised one diplomat.

"The debate is whether funds situated outside the European Union can be allowed to sell their products inside the EU," said another diplomat from one of the large EU member states, who was speaking on condition of anonymity.

The UK is alone in making such demands and will be overruled by other member states if necessary, the diplomat indicated.

"All members [of the EU's Council of Ministers] are against. The United Kingdom is isolated on this issue. When you are alone, at one point or another you have to recognise it."

The draft EU directive would "in no way affect the British [banking] industry," the diplomat added, rejecting claims in Washington that it would close Europe's doors to US funds (EURACTIV 12/03/10).

EU 'passport'

"The debate is the passport," the diplomat said, explaining that if a US hedge fund were to win authorisation in the UK, the question is whether it should then automatically be granted access to the rest of the EU market, opening "historic" new opportunities for the City of London.

"Today, as a Londoner, you are selling a US hedge fund access to the British market. Tomorrow, if you have the passport, you are selling access to 500 million European consumers."

However, he indicated there was currently no agreement in Europe to do this, meaning current practices would remain unchanged. In other words, a US hedge fund would still need to be approved separately in each of the 27 EU member states and would only receive EU-wide endorsement if it were to comply with rules that are "at least equivalent" to those in the European "passport".

"Today we have no equivalence between what's happening in the Cayman Islands, the United States, Guernsey and Jersey," the diplomat explained. "So we cannot just open Europe's frontiers."

"What we are saying is: no equivalence, no passport."

Among the biggest sticking points are investor protection and what law should be applicable when a hedge fund files for bankruptcy in the Cayman Islands, for example. "In case of bankruptcy, the applicable law is Cayman law, with Cayman judges. Are there the same guarantees as in Europe? I don't know."

The Icesave bankruptcy in Iceland has recently highlighted EU investors' exposure to the insolvency of foreign banks, with Dutch and UK consumers bearing the brunt of the financial losses (EURACTIV 09/03/10).

France draws red lines

France, the diplomat said, had two further reservations regarding the hedge funds deal. First, under the current compromise text of the Spanish Presidency, the remuneration of hedge fund managers is currently "less regulated than that of bankers". This, the diplomat indicated, is contrary to the G20 agreement and would amount to unacceptable "cherry-picking".

"When the bonus is one million dollars, we would regulate it but when it reaches 20 million, we wouldn't. That poses a problem."

Secondly, small EU states are demanding a four-year transition period to bring so-called third country depositories, where the money is kept, within the scope of the directive.

These offshore banking institutions are usually located in tax havens, making the measure controversial for countries such as France and Germany, which have lobbied for stricter regulation of tax havens at the G20.

"We are against this four-year transition period," the diplomat said, explaining that "four years is long" as "bad habits can take root".

"The day when a Madoff-style depositary throws away the savings of a lifetime, what are we going to say?"

"This would be one concession too far."

For Britain, the third country issue is a red herring as managers usually sit in London, not the Caymans, and control everything from there. "So why the hype?" the other diplomat asked.

In April 2009, the European Commission proposed a new set of rules for hedge funds and private equity firms, requiring mandatory registration and disclosure of their activities to regulators, while at the same time easing their access to European markets in the long term (EURACTIV 30/04/09). 

The main regulatory component of the proposed legislation is an obligation for EU-based managers of so-called 'alternative investment funds' to register and disclose their activities, in order to improve supervision and avoid systemic risks. 

The obligations are not applied to the funds themselves, but only to their managers, who are considered responsible for key decisions. However, critics said that the exemption of funds from the proposed new regulation would leave hedge funds and private equity free to develop their investment policies, despite the fact that their risk-prone attitudes were strongly criticised during the financial crisis.

  • 16 March: EU finance ministers to hammer out compromise on AIFMD.
  • 12 April: Parliament's economic and monetary affairs committee to vote on AIFMD.
  • July: MEPs to cast their vote on AIFMD.

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