 Last year it was a cold shower for the boffins in Brussels faced with the sudden demise of the Greek economy. This lack of preparedness has taken the EU bureaucrats by surprise and a special task force of finance ministers was swiftly set-up to analyse what went wrong. The financial distress of one so called bad apple has impinged on the stability of the euro. This instability has permeated through the 15 members of the euro club threatening contagion unless swift remedial action is taken to stem the risk of default in sovereign debt. The penny has dropped and now in the wake of the recession politicians want stronger institutions and more effective rules-based decision making. This article discusses the proposed legislation to better regulate financial markets.
In stark awareness the Greek crisis showed that a more robust framework for crisis management is needed. It is particularly relevant for the euro area where the economies, and the financial sectors in particular, which are closely intertwined and where crisis management facilities were missing. But closing the barn after the horse has bolted is often what critics say of new sanctions broadening economic surveillance to encompass macro imbalances and competitiveness. A rallying call is being made for a robust framework for crisis management in the light of defaulting member states a task force has been formed to study proposals for tighter controls. Still it is never too late to put our house in order seeing how the deep recession affected most countries and as a result has exacerbated their deficit problems. Now the task force is smarting under the pain of critics who claim that better oversight should have been in place before the sudden and unexpected collapse of credit in certain economies such as the Greek. Irish, Italian and Baltic States. Yes greed by certain bankers has been the popular war cry by critics who blame them for the credit crunch. But so far there is no proof that hedge funds did contribute to the financial crisis yet they together with banks have been selected for closure scrutiny amid claims of exaggerated bonus paid to managers. Hedge funds, thus conveniently blamed by some for exacerbating the scale of the crisis, are invariably branded by critics as essentially unregulated and opaque investment vehicles. These carry investments which engage in riskier bets than more tightly regulated banks, and achieve higher returns due to their scale of leverage, short-selling and appetite for risk.
Their superlative returns are the envy of many and to some extent this has led to a move to clip their wings. A common perception lingered that hedge funds were exacerbating the crisis in global financial markets by betting on indexes which saw the downfall of companies, and even countries. Now the time for reckoning has arrived and under the new regime, there will be a 'passport' system for hedge fund managers from outside the EU, giving them access to investors from all 27 member states so long as they are registered in one country. The reform empowers, the new European watchdog to demand information about how the funds invest and borrow money. It could also intervene by restricting trading, including a ban on short-selling. Short selling has been heavily criticised as a potential risky tool which may have landed some managers to cut corners and force them to exceed leverage limits.
It goes without saying that such tightening of the rules is much disliked by the industry as they gradually impose tighter bonus schemes on hedge fund managers, requiring them to stagger earnings over a number of years to reduce the incentive for managers to take big risks for one-off windfalls. But for Malta’s nascent hedge fund industry this would herald a new dawn of funds registrations. By 2015 all registrations under one regime (say MFSA) will be eligible to win a passport for the rest of the EU countries. The new rules, will force the funds to increase the amount of information they have to provide to regulators, including which products they are investing in. Managers' bonuses and the use of debt will also be restricted. After more than a year of internal haggling, EU finance ministers finally reached a compromise agreement in October to regulate the sector, leading to the creation of a Paris based - watch dog styled the European Securities and Markets Authority (ESMA).
France has compromised on its original stance to restrict movements of capital from outside the EU under strict passport controls. France‘s original plan was that non-EU fund managers should be forced to register with the financial regulator in each of the EU's 27 nation. Obviously London home to 80 per cent of European hedge funds (mainly US sourced) strongly objected to the French proposal stating it was discriminatory. Britain naturally complained that the exclusive passport system will impose onerous burdens, especially for smaller firms. There was some concern by the industry on EU’s over zealous attempt to introduce tighter controls over bonus levels for investment managers and on the use of debt. Essentially hedge funds will be now forced to pay managers in such a way by deferring up to 40 percent of performance-related pay so they are tied into the fortunes of the fund over a longer period of time. The concept is that traders are more cautious in their strategies.
In return for greater scrutiny fund managers will be able to acquire a “passport” to operate more easily across all EU countries .Non-European Union funds will still have access to the EU market but they need to apply for an EU-wide passport if they demonstrate regulatory "equivalence." More likely the U.S. or Singapore will be deemed appropriately regulated jurisdictions. The "compromise" sees Europe recede from plans to have all hedge funds trading across the EU authorised by a single authority, as proposed by France .The compromise allows the UK-advocated "passport" system that will allow hedge funds authorised by one regulator to operate in all 27 EU countries. In return for agreeing that measure, France got a concession on passporting for hedge funds based outside the EU, and those funds won't fall under the new regime until 2015. Subject to agreement by the European Parliament in November the rules will impose a number of constraints on the industry.
These include for instance for EMSA to limit how much hedge funds and private-equity firms can borrow if it appears that excessive risk is building up in the financial system. Hedge funds will also have to disclose more information about their holdings; private-equity firms will have to release information on the finances of the companies they own. ESMA's role in administering the new system will be phased in over several years, starting with a passport for European funds in 2013, followed by a scheme for non-EU hedge-fund managers in 2015. EMSA as the single regulator will also have emergency powers to shut down a hedge fund after a decision by EU finance minister decides it poses a threat to the stability of the financial system. In summary, the new reporting requirements and passport applications do raise compliance costs, and as stated earlier may impact smaller funds harder than larger ones. It is now expected that Funds register with national authorities and provide regular information on their holdings, potentially minimizing systemic risk.
Fund managers will also be obliged to appoint a separate custodian for hedge-fund assets and provide independent portfolio valuations. To conclude some are hinting to impose a special tax on hedge fund profits. The idea has been resisted by the industry lobby groups such as The European Fund and Asset Management Association which raised its objections to a financial activities tax and warned that the costs were likely to be passed on to investors. They add that “This could result in unwanted distortion as regards the choice for small investors between direct investment in securities and investment through collective investment undertakings,” .
So will plucking some of the feathers of the goose that lays the golden egg lead to more hissing and yield lower investment returns. The answer is yes. Let us wait and see if history has taught our politicians a lesson that in the financial jungle only the brave survive. Certainly superlative returns cannot be guaranteed in the near future if investment managers are held on a tight leash. As always- nothing ventured - nothing gained.
For further information regarding hedge funds in Malta please visit http://www.pkfmalta.com/downloads/Hedge%20Fund%20Brochure.pdf
George M. Mangion
gmm@pkfmalta.com
www.pkfmalta.com
The writer is a partner in PKF Malta, an Audit and Business Advisory firm. |