-- Karel Lannoo is a guest columnist. The views expressed are his own. He is chief executive of the Centre for European Policy Studies in Brussels --
By Karel Lannoo
BRUSSELS, June 22 (Reuters) - Don't believe the hedge fund lobbyists. The European Commission's draft rules for alternative investment bodies have been long in the making and are fully in line with what leaders of the G20 agreed at their April summit in London.
The industry may have woken up belatedly, but the approaching storm was clearly visible. The hedgies now think that if they shout loudly enough, they can still escape EU regulation. But by reacting so ferociously to a proposal which follows the EU regulatory mainstream, they are behaving as if they have plenty to hide.
The proposed rules to bring all non-harmonised funds under the EU regulatory umbrella largely mirror existing European regulations, adding a few new features to draw lessons from the global financial crisis. They introduce a single licence for such funds, which does not exist today.
The G20 summit agreed on detailed measures to combat recession and improve financial regulation. This included a commitment that "all systemically important financial institutions, markets and instruments should be subject to an appropriate degree of regulation and oversight". Leaders of the world's main economies intended to put an end to regulatory arbitrage, seen to be one of the drivers of the crisis. The G20 said hedge funds should be registered and disclose information about their leverage to supervisors. In addition, they should be subject to effective risk management.
The European Commission's proposals consistently follow this line. They did not come out of the blue. The EU executive has been consulting since 2006 on possible regulation of alternative investment schemes, including real estate, commodity and hedge funds. One of the concerns was the absence of a European passport for such investment vehicles. Some member states had regulation and allowed retail investors to buy these products, while others did not.
The European Parliament had long been calling for regulation and transparency of hedge funds and private equity. The EU legislature overwhelmingly adopted reports last September calling on the European Commission to take a legislative initiative or formally explain why this should not be the case.
A study from the Centre for European Policy Studies in April 2007 forecast a regulatory hard landing for hedge funds. This was based on the regulatory divergence in Europe; the need for more disclosure on the activities of funds and their degree of leverage; and inconsistencies and uncertainties in the impact of EU directives such as MiFID and UCITS on non-harmonised funds.
The financial crisis accelerated and crystallised the positions of policymakers, ending the cosy environment in which the industry had operated. The collapse of Lehman Brothers highlighted the risks to financial stability from highly leveraged positions and trading techniques used by alternative funds such as short selling. The Commission proposal follows the provisions of the Market in Financial Instruments Directive (MiFID), on the conduct of business, organisational (including outsourcing), reporting and prudential requirements. The draft added elements that have come up in the crisis, such as the need for appropriate liquidity management, segregation between asset management and the depositary function, and additional reporting requirements for highly leveraged funds.
The Commission plan will not apply to leveraged funds with assets below 100 million euros, or non-leveraged funds below 500 million euros, implying that roughly 30 percent of hedge fund managers would be captured by the directive, or 90 percent of the funds. Leveraged funds of more than 100 million euros are considered as having a cross-border dimension. Some hedge funds are already considering splitting to avoid the threshold and evade any regulatory obligation. The transparency threshold for private equity funds with stakes in non-listed companies is 30 percent, compared to 3 percent for listed companies.
In addition, "empty" voting rights (a common tool for alternative funds) will be indirectly included in the threshold. To level the playing field, the rules apply to managers of alternative investment funds, not only to the funds. In this way, and by adding a reciprocity provision, the Commission will ensure that the whole non-harmonised funds sector is covered.
This may lead to some inconsistencies, as the directive may have been drafted only with hedge funds or private equity groups in mind and not, for example, real estate funds. Nevertheless, it has the advantage of being comprehensive. The reciprocity provisions are most open to criticism as extra-territorial and protectionist. But if world leaders keep their G20 promises, this will be not a problem, since the EU accepts the principle of regulatory equivalence.
The industry is wrapping itself in the British flag in the hope that Prime Minister Gordon Brown will defend it as a jewel in the City's crown. But the hedgies should remember it was Brown who chaired the G20 summit that put hedge fund regulation on the global agenda. (Karel Lannoo; Centre for European Policy Studies; www.ceps.eu)