By John Gapper
Published: Last updated: May 19 2010 20:07
A few financiers in London’s Mayfair must be considering life on a smaller island or by a Swiss lake.
This week’s vote by European finance ministers to curb the activities and pay of hedge fund managers was followed by the German finance regulator trying to limit “speculation” by imposing restrictions on short-selling.
German politicians have long complained about the destabilising effects of hedge fund and private equity “locusts” in financial markets. Now they and other European Union legislators are using the subprime mortgage and Greek debt crises to justify a crackdown.
This might be fair if hedge funds had caused either event, but they did not. Banks such as IKB, which went on a collateralised debt obligation bender with its “Rhineland” structured investment vehicle before collapsing, were more to blame. I have not, however, heard Germany call for European oversight of its industrial and regional banks.
The French and German governments have often wanted to subdue Anglo-Saxon finance and now have other EU members behind them, including Spain, holder of the current EU presidency. But the Alternative Investment Fund Managers Directive that was this week thrust on George Osborne, Britain’s new chancellor of the exchequer, is protectionist, prescriptive and perverse.
First, it is protectionist, both towards London and elsewhere. Eighty per cent of the EU’s hedge funds and half of its private equity funds are in the City. The directive allows other European governments to tell the Financial Services Authority how to supervise them.
The directive also has a “Fortress Europe” quality, for it imposes strict conditions not only on non-EU hedge funds selling to European investors, but on the freedom of EU investors to put money into funds based outside its borders.
The European parliament and national governments are tussling over the details, with the parliament at least sticking to the principle of the single market – that funds should be able to get a marketing “passport” rather than seeking approval in each EU country.
Still, either version makes it harder for institutions to invest as they see fit, which is a bad outcome unless you are a government that would like cash to stop flowing to what you regard as tax-avoiding and laxer regulatory centres such as Geneva and New York.
Charles River Associates, in a study for the Britain’s Financial Services Authority, estimated that European investors will no longer be able to invest in 40 per cent of non-EU hedge funds and 35 per cent of non-EU private equity funds if the directive becomes law as drafted earlier this year.
Second, it is prescriptive. Some elements are reasonable and in tune with the way the market is going. After the Bernard Madoff affair, followed by the arrest last year of Raj Rajaratnam, founder of Galleon Group, on insider trading charges, investors are warier of putting cash into hedge funds with poor oversight and little transparency.
Hedge funds will have to be more open in reporting exposures and to meet tighter compliance standards. But such a change did not require a pan-European law – it would not only have been demanded by the market but imposed by national regulators such as the FSA.
Meanwhile, the directive mandates limits on leverage and pay that may be suitable for big financial institutions but are not required for small ones, which most hedge funds are. In fact, it is helpful to have an incentive for high risk and reward activities to shift from “too big to fail” banks into funds.
Having established the principle that the EU can impose hedge fund rules on the UK, what could come next? EU politicians were making noises yesterday about transmuting the German attack on short-selling into pan-European regulation.
All this will encourage funds based in London that do not raise much from EU investors to move offshore since, unlike banks that threaten to leave town but rarely do so, hedge funds are mobile. BlueCrest and Brevan Howard, two of the biggest funds, are already considering moving operations to Geneva to avoid tax and regulation.
Last, it will have perverse effects by giving a competitive advantage to larger, diversified hedge fund groups. This point was cited by Peter Clarke, chief executive of Man Group, as one incentive for its merger with GLG Partners to form a group with $63bn in funds under management.
“The more you raise regulatory barriers to entry, the more you provide an incentive to get bigger,” says Sebastian Mallaby, a senior fellow of the Council for Foreign Relations and author of More Money Than God, a forthcoming book about the rise of hedge funds.
Regulators ought to think about the systemic consequences of this. One lesson from the 2008 financial crisis is that institutions that are too big to fail can cost taxpayers a lot of money. In contrast, about 1,500 hedge funds are thought to have liquidated in 2008 without any need, or call, for a bail-out.
When hedge funds act in unison, it can have systemic effects. Charles River estimates that the unwinding of fund portfolios during 2008 caused $2,400bn of selling into weak markets – as well as the worst-ever year for hedge fund performance.
But there is a point to encouraging small funds rather than leviathans that might need support. German voters are upset at having to rescue proflicate Greeks; do they want to bail out Mayfair hedgies too?
Copyright The Financial Times Limited 2010
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