SJ/EP- n°2493/Div.
Interest representative register number:
5975679180-97
Mr David Wright
Deputy Director General
Directorate General Internal Market and Services
European Commission
2/4 rue de Spa
1000 Brussels
BELGIUM
Paris, 31 January 2009
AFG’S RESPONSE TO THE EUROPEAN COMMISSION CONSULTATION ON HEDGE FUNDS
The Association Française de la Gestion financière (AFG)[1] welcomes the opportunity given by the Commission services to express the point of view of the French asset management industry on hedge funds. AFG is registered under the number 5975679180-97in the European Commission's register of interest representatives.
AFG has been very active in the discussions relating to hedge funds for several years, and we are glad to see that the European Commission decides to deepen the debate on this topic for potentially setting an EU framework on hedge funds.
Before entering the details of the questions raised by the Commission, we want to make the following general remarks.
AFG feels particularly concerned by this topic since among its 409 management company members, many are specialised in hedge funds or funds of hedge funds. Let’s recall that the French on-shore regime for hedge funds and funds of hedge funds, although set up only in 2003/2004, already amounts to more than 30 billion euros.
The recent market events reinforced the public wonderings on the need or not to regulate hedge funds, and if yes in which way. We think that the main aims should be the following:
-The Commission should avoid giving too much weight to the political dimension of the debate surrounding hedge funds in the recent period, to stick only to a de-passionate and lucid analysis of the current state of play and the ways to explore;
-There is a clear need for an EU regulatory framework on hedge funds, whichwould be additional, and not interfere with, the already highly regulated European investment funds covered by the so-called ‘UCITS Directive’;
-Such an EU framework for hedge funds should be envisaged in a wider approach of non-harmonized funds;
-Such a framework should answer the two major current issues regarding hedge funds in the EU: how to protect investors which are directly or indirectly concerned by such products, and how to build on that basis a strong EU hedge fund industry which would be even more competitive at global level;
-In our view, it would require providing an EU regulatory framework covering both hedge funds as such and the whole chain of players involved (managers, depositaries, prime brokers).
The four crucial points to be taken into account, clearly illustrated by the Madoff case recently, are:
-the porosity between the so-called ‘wholesale’ market and the ‘retail’ market.
As we have warned since 2005, the losses of the wholesale part of the market end more often than not in the retail part of it. Apart from pure family offices, the (huge) losses made by professional players have to be borne either by retail investors (through ‘retail cascades’, for instance in pension funds), by tax-payers (e.g. when municipalities made wrong investments) and shareholders of the relevant institutional investors. The paradigm of a clear-cut between the ‘wholesale’ world and the retail world has now to be repealed, when we face the reality of facts: all types of investors have to be protected;
- we are therefore not supportive of the idea of a “Private Placement regime” in Europe which would in practice completely deregulate Hedge Funds, by prohibiting Member States from restricting the free marketing of off-shore funds on their soil. However, we are open to developing a European Passporting for on-shore Hedge Funds towards sophisticated investors, complementary to a wider passporting towards a larger scope of investors;
-the clear opposition between the off-shore world and the on-shore world of hedge funds.
In the Madoff case, no one can currently identify the amount of losses in off-shore funds, because of the lack of transparency inherent to the off-shore world. If the Commission wants to protect investors and also to promote a clean and competitive EU hedge fund industry, it has to set up an on-shore regime answering these two objectives. First, facilitating the setting up of an EU on-shore hedge fund vehicle (‘alter-UCITS’), which would be managed, administrated and deposited by EU on-shore players. The Madoff case shows clearly that once investors want their money and assets back, it is easy to legally attack on-shore funds and players - but in case of off-shore funds (and even if they are managed by on-shore players), or in case of non-European players (like Madoff Securities), then real action is more than difficult;
-Of course, developing such an EU regulatory framework for non-harmonised funds, including hedge funds, will not make disappear the off-shore funds. But if this EU regime finds the appropriate mix between product regulation (kept flexible enough) and players’ regulation (which should be the most important part of the EU framework), then this regime will be competitive vis-à-vis off-shore regimes and will develop the on-shore marketshare vis-à-vis the off-shore one. By bringing thus light on a wider part of the hedge fund world, both investors’ risks and systemic risks will be reduced in due proportion.
The ‘alter-UCITS’ framework would define minimal rules for the products as well as the type of players authorised to manage, administrate, deposit and sell them. We could, for instance, imagine that the hedge fundsshould comply with the following requirements:
(a)be subject to a registration and monitoring within the European Union;
(b)be managed by a management company showing fitness and appropriateness in the field;
(c)be controlled and have its assets safekept by a depositary. Such a depositary should have clear and harmonised role and responsibilities across the European Union. It is a crucial point for the development of an effective and safe EU regime for on-shore hedge funds;
(d)follow minimum rules, monitored by an auditor, on asset valuation and regularly publish their NAV.
These are examples of the fields that could be covered by the EU regime. We are willing and ready to collaborate more on European hedge fund regulation if the European Commission is now interested to do so.
Having said that, you will find below the answers to your specific questions.
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SCOPING THE ISSUES:
Question 1: 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 their distinct features justify a targeted assessment of their activities?
The European Commission does not define the hedge funds and identifies three characteristics, which, in our opinion, are not entirely convincing or relevant for hedge funds:
(a) focus on delivery of absolute return: many of our professionals manage funds that have an absolute return objective without being hedge funds. Therefore this criterion is not significant;
(b) a relatively high and systematic use of leverage: most of the hedge funds are not leveraged. If we take the long-short category for example, their gross leverage is normally below 2 and currently closer to 1. In any case, their gross position is achieved through borrowing shares and selling them, which means they are actually long cash. By contrast, some non-hedge funds can have a leverage of at least 2 and often more, through derivatives;
(c) institutional investors/sophisticated investors buy a lot of different investment products but hedge funds only represent a very small portion of their investments, always lower than 5% and generally lower than 2%. In addition, at the end of the day investments done by institutional investors have finally an impact on retail investors, tax-payers or shareholders. Moreover, some retail investors already directly buy, subject to conditions, hedge fund units.
A more relevant criterion would be short selling since most of hedge funds use short selling techniques whereas UCITS cannot short sell, except through derivatives. But it is not a satisfactory criterion either.
We believe that the concept of hedge fund as developed by the European Commission is too imprecise and have more a media effectthan a true substance. One cannot imagine that regulations be built on such vague concepts.
But work on definition is not necessarily a cul-de-sac. Its difficulty did not prevent many Member States to establish on-shore hedge fund regimes in the last decade – see EFAMA survey published in November 2005[2]. Therefore it should not be an obstacle to set up an EU regulatory framework for hedge funds – on the contrary, such an EU framework would help building, above the existing fragmented national regimes, an additional EU regime for hedge funds with the two associated benefits: cross-border product passport; and worldwide alter-UCITS brand (complementary to the existing UCITS brand).
France is among these Member States that have hedge fund managers regulated (as any other financial entity) and reporting to the French regulator. This pattern has allowed the development of the hedge fund industry in France. Today, more than ever, there is a crucial need to set up a European regime to frame the hedge fund industry. We will not succeed by trying to precisely define the products themselves but we will succeed by supervising the chain of players in the hedge fund business. Not only we will bring confidence to the national supervisors and investors but we will also create a competitive European brand for the hedge funds. Based on the UCITS label and framework; we believe that the European Commission should work on an alter-UCITS regime, dedicating a part to the hedge funds (as explained above).
Question 2: Given the international consideration of hedge fund activity, will a purely European response be effective?
There is no reason in itself why Europe could not act if there are strong reasonsfor regulating. The European regulatory landscape is indeed nearly complete today and is already indirectly touching at some aspects of Hedge Funds. Europe already regulates banks, UCITS, investment companies etc. We do not see any reason why Europe could not regulate hedge funds while the whole chain of players involved is currently regulated from other perspectives.
On the contrary, we welcome the (although late) involvement of Europe in the current worldwide debate.
Of course, we do not believe that a purely European response will be effective on its own, given the fact that currently most hedge funds are domiciled off-shore.
We need to get a European response but this should also be part of a broader discussion at international level. The hedge fund products do not stop at the boundaries of the European Union. In the US, the new SEC chairperson has already said she would propose action: shall we wait for our American friends to provide us with an answer or shall we be active in the debate? That is the question.
Indeed, taking into consideration the international dimension and impacts should not delay the European response.Getting an EU regime for on-shore hedge funds would already be a tremendous progress as compared to the existing situation. If 27 Member States are already able to converge on a pan-European onshore hedge fund brand (beside the national regimes, which would still be allowed), it would help getting convergence at global level later on.
We also wish to insist on the need to analyse carefully the regulatory developments that are discussed in the United States regarding Hedge Funds, in order to avoid any unintentional discrimination against EU interests.
Moreover, whereas US-based managers can create subsidiaries in Europe to manage European-based funds and delegate their management back to the US, this is not possible for European managers: US regulations does not allow delegation of advisory functions outside the reach of the SEC. There would therefore not be any route that would allow European asset managers to market their services to US-based investors.
We therefore urge the EU Commission to follow regulatory projects in the US, with a view at making sure there is an equal playing field on both sides of the Atlantic. In the meantime, we urge the EU commission to suspend any private placement project that would further deteriorate such level playing field by making any non-registered fund managed by a US-based advisor freely marketable to any European-based qualified investor.
SYSTEMIC RISKS-
Question 3: Does recent experience require a reassessment of the systematic relevance of hedge funds?
Question 4: 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? Do we need alternative approaches?
As already recognized by the European Commission itself, hedge funds are usually liquidity providers and cover a large variety of strategies: as a group, they clearly cannot be taken collectively responsible for the current crisis.
However, we recognize with the European Commission that two major topics have to be tackled in relation to hedge funds. First, the topic of transparency, for which there is a clear-cut between on-shore domiciled hedge funds and off-shore domiciled hedge funds. The current on-shore hedge funds have been fully transparent to their relevant regulators – contrary to offshore funds. Second, in terms of investor protection, the ‘retail cascades’ mean that it is currently very difficult to identify where the risks coming from hedge funds are finally located.
The current crisis shows clearly that the existing provisions are not enough. As already mentioned above, regulators have difficulties to identify and isolate the risks related to hedge funds activities - when hedge funds are domiciled offshore. By setting up a competitive EU framework for on-shore hedge funds, both flexible enough in management techniques and transparent enough to answer regulators’ and investors’ concerns, we would allow for bringing on-shore one part of what is currently domiciled off-shore. Of course off-shore centers will always exist, but if we are able to reduce their marketshare as compared to on-shore centers, then the level of systemic risk will be greatly reduced.
Question 5: 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?
Hedge funds are part of the asset management industry. Their losses, when any, are borne by the investors. As such, these losses are therefore not likely to create systemic risks strictly speaking. Banks properly control their hedge funds risks, one could even say extremely conservatively. There is no reason to believe that banks are taking excessive risks with hedge funds and no losses of systemic proportion have been incurred by banks. In any case, the regulation of bank risks is a banking regulation issue, not a specific hedge funds regulation issue.
However, authorities do not have the tools to monitordirectly exposures of the core financial system to hedge funds, or the contribution of hedge funds to asset price movements. No one knows currently the overall exposure of offs-shore hedge funds on the financial markets – because of their offshore domiciles. The first tool would be to limit the exposure of hedge funds. The second tool for authorities would be to get reports from hedge funds; but in the case of offshore funds it is very difficult to monitor.
In principle, regulators should have the possibility to request information from hedge funds directly and on an ad-hoc basis. But to be realistic, no one can envisage such an approach – as otherwise offshore centers would not present advantages anymore.
Therefore, the only solution – at least for EU regulators – is to set up a competitive EU framework for onshore domiciled hedge funds, which would increase the marketshare of on-shore hedge funds as compared to offshore ones. This EU framework for on-shore hedge funds – ‘alter-UCITS’ – should be mainly centered on the relevant chain of players (managers, prime brokers, administrators, depositaries) and their due diligences, in particular their reporting obligations. The design of the vehicle itself should be left rather flexible in order to make it competitive vis-à-vis offshore centers.
MARKET EFFICIENCY AND INTEGRITY-
Question 6: 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?
Question 7: Are there situations where short-selling can lead to distorted price signals and where restrictions on short-selling might be warranted?
Question 8: 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?