Prior to the end of 2008, the European Commission (Commission) launched a public consultation on policy issues arising from the activities of the hedge fund industry in Europe, as part of its work in reviewing the regulatory and supervisory framework for all financial market actors in the EU. This consultation was launched in response to concerns as to the impact of the activities of highlyleveraged investment vehicles on the stability of the financial system and a perceived lack of transparency of hedge funds vis-à-vis regulators and other financial market actors. Previous analysis of the risks presented by hedge funds to the European financial and economic system by the Commission suggested that all significant risks were adequately addressed by a combination of EU legislative measures, national regulation and self-regulatory codes. As readers will be aware however, more recently, recommendations of the European Parliament on the issue of hedge fund regulation had called for the Commission to move forward with initiating legislation covering hedge funds.
The premise of the Commission’s consultation on hedge fund activity is that all financial markets, products and participants should be regulated or subject to oversight as appropriate to their circumstances. By way of overview, the consultation covers the following headings:
DEFINING THE SCOPE OF POSSIBLE REGULATORY INITIATIVE
In its consultation paper, the Commission identifies that, as a common denominator, hedge funds are collective investment vehicles which can generally be distinguished from other types of investment fund by the following characteristics:
- Focus on delivery of absolute returns even in the context of declining markets through the use of hedging and flexible investment strategies;
- These investment strategies typically translate into a relatively high and systematic use of leverage, through borrowing, short-selling and derivatives positions;
- Traditionally, the hedge fund investor base has been confined to institutional or other sophisticated investors which has led regulators to exempt hedge funds from many investment protection and disclosure requirements (although it is noted by the Commission that the extent to which hedge funds are exempt from regulatory requirements differs across countries).
In this regard, the Commission has put the following questions to respondents for the purposes of the consultation:
- Are the above considerations sufficient to distinguish hedge funds from other actors in financial markets (especially other leveraged institutions or funds)? If not, what other/additional elements should be taken into account? Do the distinct features of hedge funds justify a targeted assessment of their activities?
- Given the international dimension of hedge fund activity, will a purely European response be effective?
It can be said that recent developments have demonstrated that hedge funds may impact broader market considerations and dynamics and the Commission notes that it is essential that front-line regulators are in a position to monitor the build-up of risks in this sector, so that they are able to form an accurate and timely judgement on the extent of aggregate leverage and on the crowding of hedge fund trades. The consultation invites views on whether existing systems of macro-prudential oversight are sufficient to allow regulators to monitor and react to risks originating in the hedge fund sector and transmitted to the wider market through counterparties, including prime brokers, and through impact on asset prices, and raises the following specific questions for respondents:
- Does recent experience require a re-assessment of the systemic relevance of hedge funds?
- Is the “indirect regulation” of hedge fund leverage through prudential requirements on prime brokers still sufficient to insulate the banking system from the risks of hedge fund failure? Are alternative approaches required?
- Do prudential authorities have the tools to monitor effectively exposures of the core financial system to hedge funds, or the contribution of hedge funds to asset price movements? If not, what types of information about hedge funds do prudential authorities need and how can it be provided?
MARKET INTEGRITY AND EFFICIENCY
The Commission’s consultation seeks to review whether and under what circumstances the activities of hedge funds pose a threat to the efficiency and integrity of financial markets, and focuses on concerns around short selling. In this regard, the Commission asks respondents:
- Has the recent reduction in hedge fund trading (due to reduced assets and leverage, and short-selling restrictions), affected the efficiency of financial markets? Has it led to better/worse price formation and trading conditions?
- Are there situations where short-selling can lead to distorted price signals and where restrictions on short-selling might be warranted?
- Are there circumstances in which short-selling can threaten the integrity or stability of financial markets? In combating these practices, does it make sense to tighten controls on hedge funds, in particular, as opposed to general tightening of market abuse disciplines?
In its consultation, the Commission considers whether regulators should concern themselves more with the way in which hedge funds manage the risks to which they and their investors are exposed, value their asset portfolios and manage any potential conflicts of interest. The Commission notes that traditionally, regulators have not concerned themselves with overseeing the risk management and asset valuation processes of hedge funds to the same degree as for retail investment funds, and that although the Financial Stability Forum has previously called on the hedge fund industry to deliver improvements with respect to risk management processes and valuation techniques (and selfregulatory codes have been developed in response), it is not yet clear whether these have had a material impact on the robustness of the internal processes of hedge funds, particularly in stressed conditions. In light of these considerations, the question formulated by the Commission for respondents under the heading of risk management are:
- How should the internal processes of hedge funds be improved, particularly with respect to risk management?
- How should an appropriate regulatory initiative be designed to complement and re-inforce industry codes to address risk management and administration?
TRANSPARENCY FOR INVESTORS AND INVESTOR PROTECTION
The consultation invites views on whether hedge fund investors are adequately protected, and whether they receive appropriate information required for sound investment decisions. In this regard, the Commission asks:
- Do investors receive sufficient information from hedge funds on a pre-contractual and ongoing basis to make sound investment decisions? If not, where do the deficiencies lie? What regulatory response if any is needed to complement industry codes to make a significant contribution to the transparency of hedge fund activities to their investors?
- In light of recent developments, do respondents consider it a positive development to facilitate the access of retail investors, subject to appropriate controls, to hedge fund exposures?
The purpose of the Commission’s consultation on European hedge fund activity is to provide direction for an appropriate regulatory initiative, if deemed appropriate, and the Commission intends that the responses to the consultation will also serve as the basis for a fresh and up-to-date European input into the parallel reflections on hedge funds at international level through the G-20 and IOSCO process.
In this regard, the Commission notes the importance of open dialogue arising from the consultation between regulators and all interested parties, including investors and the hedge fund industry, if the appropriate conclusions are to be drawn.
The deadline for responses to the consultation is 31 January 2009, and the responses and feedback received will subsequently be discussed at a high-level conference in Brussels in late February 2009.