Demand for increased regulatory intervention since the financial crises of 2008 has been unabated. In the UK this has manifested in many ways: for example, the current Government’s plans to extend the powers of the Bank of England and consequently dismantle part of the Financial Services Authority, along with changes to corporate governance rules following Lord Turner’s work. Two particular targets for European attention, which will have a direct effect on the cost of investment services used by many UK pension funds, are new draft directives to regulate alternative investment fund managers (‘AIFM’) and the over-the-counter derivatives (‘OTC’) markets.
The AIFM Directive
The AIFM Directive was originally proposed in April 2009 in response to the market volatility brought about by hedge fund managers in particular, many of whom provide their services from relatively lightly regulated jurisdictions outside the EU. The scope of the Directive is actually much wider than hedge funds alone as it would encompass private equity and venture capital funds and in fact any collective investment arrangement which raises capital from a number of investors and which is not covered by the UCITS Directive1 which applies to regulated funds suitable for retail investors. Pension funds are, mercifully, given an express exemption from the Directive’s scope, ie they are not deemed to be alternative investment funds themselves.
Because of the very extensive scope of the draft Directive, it has been a political football since the European Commission’s first draft and several revised proposed drafts have been put forward by different member states when acting as president of the European Council.
The AIFM Directive seeks to regulate alternative investment fund managers, rather than the funds themselves where the assets under management exceed certain financial thresholds. If a manager is responsible for a portfolio of no more than €100m (whether leveraged or not) or a larger portfolio not exceeding €500m where the assets are not leveraged and investors have no redemption rights exercisable during the first five years of their investment, then the Directive will simply require registration of the AIFM in its home member state and the provision of information to relevant authorities concerning the activities of the fund(s) in question. For fund managers who control assets not covered by the above conditions the full scope of the Directive will apply. The scope is very wide and includes rules in: conduct of business, conflicts of interest, risk management, liquidity management, permissible leverage limits, valuation of fund assets, remuneration of the AIFM, delegation, disclosure, marketing and reporting requirements.
Perhaps the most contentious effect of the AIFM Directive concerns the additional costs which will be faced by institutional investors for pension funds for whom the whole panoply of conduct of business rules contained in the draft Directive may be considered to be excessive. Since the detail of the Directive is aimed at essentially creating a retail investment environment which does not distinguish between retail and institutional investors, many representations have been made on behalf of the UK pensions industry that the draft Directive goes too far. Two specific areas illustrate this point.
First, there is a new requirement for all AIFMs to appoint depositaries to act as custodians of investor funds with appropriate conflict of interest provisions so that an AIFM cannot perform that role. The draft Directive prescribes that the depositary shall be liable in contract either to the fund itself or to the investors and will also be liable for the acts of any sub-custodian appointed by it, subject to certain conditions. Depositaries will consequently argue that the cost of custody must rise in order to meet such liability standards (even if these eventually fall below the level of strict liability which was originally proposed by the Commission).
The second area of contention concerns the marketing of alternative investment funds to investors in EU member states from outside the EU or where such funds are managed by a non- EU based manager. In previous drafts of the Directive the Commission proposed that it would actually be prohibited for pension funds and other investors to invest in third country alternative investment funds, which would clearly have an impact on freedom of investment choice and potentially performance, thereby maybe leading to funding consequences for sponsors. In a meeting on 19 October this was resolved. Cutting through a large amount of detail, the headline is that third country funds will eventually have access to a passport to sell to investors in the EU.
OTC Derivatives Directive
In September 2009, after much analysis of the causes of the global financial crises of 2008, the G20 leaders issued a statement at their Pittsburgh summit which declared that “all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end 2012 at latest. OTC derivatives contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.” The European Commission has not been idle in implementing this global policy statement and in July 2010 issued a consultation document: Derivatives and Market Infrastructures. The consultation closed in September and was followed by a proposal in October from the European Commission to regulate derivatives markets.
The rationale for creating an infrastructure for OTC contracts goes back to the lack of transparency about reporting of OTC contracts which currently applies. Unlike exchange-traded contracts such as options and futures, OTC derivatives are privately negotiated between two counterparties (generally a bank and either a corporate entity or an institutional investor such as a pension fund). This lack of transparency led Michel Barnier, the Commissioner for the Internal Market and Services to remark “no financial market can afford to remain a wild west territory… the absence of any regulatory framework for OTC derivatives contributed to the financial crisis and the tremendous consequences we are all suffering from”. In making this statement Mr Barnier, we presume, could not have intended any reference to the many carefully considered risk management derivative investment programmes implemented by trustees of UK pension schemes – but sadly everyone is tarred by the same brush by such emotive language.
In practice, what the Commission’s regulatory proposal will do is to create a framework under which all OTC contracts which are capable of being standardised (ie which fit into certain predetermined eligibility criteria) would have to be cleared through a new central counterparty (‘CCP’). Globally there are about a dozen such bodies in existence, all but one of which is located in Europe or the US. This means that instead of a pension fund, for instance, contracting with a bank directly for an interest rate swap, it would enter into a contract with a CCP instead. The CCP would hedge out the risk to other market participants who wanted to buy that interest rate exposure. CCPs would also be capable of contracting with each other (a structure which is known as “inter-operability”).
The other part of the Commission’s proposal for establishing a transparent market is to require all trades in OTC contracts to be reported to trade repositories. Commercially sensitive data would be kept confidential to buyers and sellers but importantly such trade repositories would be under a reporting obligation to prudential supervisors which does not currently exist.
So how does this proposal affect pension funds as users of derivative products? At one level, the move to standardise contracts and create a central clearing market place may, in the long run, result in reduced costs for investors combined with greater security by the reduction of operational risk in the market. However, the Commission’s proposals will significantly increase costs in the short run and may embed additional costs in the nature of standardised contracts because of collateral requirements which do not currently apply to OTC contracts. Currently exchange-traded contracts such as futures and options require the use of margin payments (both initial and variation once a contract is in force) to ensure that investors do not end up running positions which expose them to unacceptable losses if mark to market value of the contract moves against the investor. This contrasts with the way that collateral is currently held and transferred by counterparties under existing OTC contracts. The Commission believes that bilateral agreements often result in inadequate security being held against counterparty failure, which is a risk posting higher amounts with a CCP will obviate.
The Commission recognises that not all OTC contracts can be treated and cleared for a CCP because there are naturally limits to the standardisation of any type of contract. This does not mean that the rules will be disapplied; in fact, higher capital requirements will be applied to “financial counterparties” who will, after all, still be under a reporting obligation to the trade repository. It is too early to tell whether the types of OTC contracts which pension funds typically engage in will fall within this category of bespoke non-standardised contracts and therefore run the risk of calling for higher capital requirements. However, since the current documentary model is based on a derivative transaction being entered into by a corporate entity with a banking counterparty, it would not be surprising if the non-standard nature of pension fund trustees or other non-corporate entities led to such categorisation. This could in theory even extend to those UK pension schemes who are using currency hedging by way of forwards to manage the currency risk in their non-Sterling investments. Pension funds themselves are categorised under the Commission’s proposal as “financial counterparties” notwithstanding the fact that they are not direct market participants in the way that insurance companies, investment managers and banks are. Lobbying to exempt pension funds from this categorisation has fallen on deaf ears.
There will be further regulatory consequences for implementation of the Commission’s proposals in other areas, such as amendments to the Capital Requirements Directive, the Markets in Financial Instruments Directive and the Market Abuse Directive. One thing is certain, the cost of trading in derivatives will rise for end users such as pension funds.