Alternative Investment Management Association

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1 Mr. Jörgen Holmquist Director General DG Internal Market and Services, European Commission, B-1049 Brussels Belgium 8 April 2009 Sent via to: MARKT-G1@ec.europa.eu Dear Mr. Holmquist, The Alternative Investment Association Limited (AIMA) welcomes the opportunity to make comments to the Commission regarding (1) the recommendations included in the Report of the High Level Group on Financial Supervision, and (2) the proposed initiatives outlined in the Commission s Communication of 4 March to the Spring European Council 1. These comments are restricted to those recommendations and proposed initiatives on financial supervision only. About AIMA AIMA is the trade body for the hedge fund industry globally; our membership represents all constituencies which make up the hedge fund sector including hedge fund managers, fund of hedge funds managers, prime brokers, fund administrators, accountants and lawyers. Our membership comprises more than 1,200 corporate bodies in 43 countries, with over half of our members based in Europe. Since its establishment in 1990, AIMA has worked with the aim of enhancing the regulatory framework in which our members operate. AIMA has a central tenet that good regulation makes for good business and has developed an excellent reputation with regulators worldwide. We have produced, over many years, a number of sound practice guidelines which have been widely used across the industry. AIMA is not a self-regulatory body. New members are vetted for their bona fides; manager members must be supervised by a recognised regulator in order to qualify for membership. AIMA is currently working with the various international bodies, on behalf of its membership, in order to develop a stronger regulatory landscape which is both effective and capable of allowing the flexibility for innovation which hedge funds need in order to prosper. 1 European Commission: Report of the High Level Group on Financial Supervision [25 February 2009] and Communication for the Spring European Council Driving European Recovery Volume I [COM(2009) March 2009].

2 Recommendations of the High Level Group on Financial Supervision AIMA is encouraged that the High Level Group has recognised that hedge funds were neither the cause of the financial crisis nor a significant part of the problem that has so damaged our capital markets. The Report of the High Level Group on Financial Supervision (the Report ) states that hedge funds played a role in amplifying the market effects of the crisis through massive selling of shares and short selling transactions. This effect should not be exaggerated many hedge fund managers were forced to deleverage and sell into down markets due to the overall deleveraging in the markets; yet their sales volumes represented only a fraction of overall selling by market participants. Hedge fund managers held short positions in a wide range of equities, like many other market participants. It must be noted that all independent research of short selling and short selling restrictions shows that the bans actually had detrimental effects on the markets 2. In the Report s proposals for policy and regulatory repair, it states that any future regulation should concentrate on the major sources of weaknesses of the present set-up and strengthening regulatory oversight of institutions that have proved to be poorly regulated. Following these recommendations, we do not see the need for further regulation of the European hedge fund industry as it has not proven itself to be poorly regulated. Under the extreme recent market conditions, the model by which hedge fund managers are regulated has proven itself to be robust. There have been some fund closures in Europe; however, these have been almost universally orderly and have posed no systemic risk; and losses have been absorbed by investors in the funds (institutional investors, qualified investors and high net worth individuals) rather than by credit institutions or the tax payer no bail-out has ever been required. AIMA s comments on the specific supervision recommendations of the report applicable to hedge funds and hedge fund managers are as follows: Recommendation 7 ( parallel banking system ) Recommendation 7 of the Report advocates extending appropriate regulation to all firms or entities conducting financial activities of a potentially systemic nature. AIMA agrees with this recommendation and we have already pledged our support for a global manager-authorisation and supervision template based on the UK s FSA model. In Europe, 80% of hedge fund assets are managed in the UK where all managers are fully authorized and supervised by the FSA. Within the UK s regime, a hedge fund manager must obtain authorisation from the FSA before undertaking any designated investment business. Such authorisation process includes an examination of the business plan, of the systems and controls to be put in place, of the fitness and propriety of those put forward as responsible for controlled functions a series of critical functions in the life of any financial services business, such as director/partner function, compliance function, money laundering reporting function etc. 2 Independent research was carried out by CASS Business School; the London Stock Exchange and Columbia University.

3 The UK also has a specialist supervisory team to oversee the largest hedge fund managers (currently around 40 in number), which are deemed to be of importance from a systemic point of view. As far as the EU is concerned, hedge funds/hedge fund managers are subject to a number of the directives which form part of the EU s Financial Services Action Plan. These include the Markets in Financial Instruments Directive (MiFID), the Capital Requirements Directive (CRD), the Market Abuse Directive (MAD) and the Transparency Directive (TD). These directives have been fully implemented in the UK and are incorporated in the FSA s rules. This micro-level supervision has proven effective and efficient and is a model that could be extended to include other European national regulators where the hedge fund manager has relevant cross-border activity. That said, it should be noted that very few hedge fund managers meet any reasonable definition of systemically relevant. Recent events have proven that hedge funds do not pose a substantive risk to financial stability. Although it remains important that the hedge fund industry worldwide plays its part by providing the information that will enable the international authorities obtain a good sense of what is happening within the global economy; we do not think there is a significant threat in terms of systemic risk from the hedge fund sector itself, given the low levels of leverage, counterparty risk, and assets under management. Recent figures from the European Central Bank and the UK FSA show that leverage levels of hedge funds are in the region of 1 times net assets; these are extremely low in comparison to the banks (whose leverage levels have been between 30 and 60 times, as noted in the Report). Indeed, the relative size of the global hedge fund industry compared to the banking sector is small - there are some individual banks that have bigger balance sheets than the entire global hedge fund industry. Recommendation 7 calls for these systemically important hedge fund managers to provide information concerning their strategies, methods and leverage, including their worldwide activities. We have already recommended that periodic information should be collected from all market participants on (1) leverage, volatility and liquidity according to asset class and investment strategy; and (2) major risk concentrations; and that this information should be disclosed to the relevant nominated national supervisor/ regulator only. Supervisors need to be very selective about the hedge fund managers (management companies and banks) viewed as systemically relevant and warranting micro-level supervision. Supervisors should set clear, objective criteria for hedge fund managers and national supervisors to facilitate the extension of supervision where required. It is our view that disclosure is only necessary by hedge funds managers a minimum threshold level and that this threshold will have to be agreed with the regulator for each asset class and investment strategy type. Recommendation 16 ( European Systemic Risk Council (ESRC) ) Recommendation 16 sets out provisions for a proposed European Systemic Risk Council. AIMA s concerns on this proposal regard the proper flow of information between the ESRC and microprudential supervisors, which may include some supervising hedge fund managers.

4 National regulators should be responsible for collecting, aggregating and transmitting any required information to any new European body. Duplication of reporting should be avoided while the information and the management of this information by national regulators should not risk disclosure of hedge fund manager strategies to the market. Hedge fund investors pay to benefit from hedge fund strategies and investment decisions. Broad public disclosure requirements and the indiscreet management of sensitive information devalue these strategies and investment decisions. Recommendation 20 ( more harmonised financial regulations, supervisory powers and sanctioning regimes ) Recommendation 20 calls generally for a strengthening and harmonisation of regulation, supervision and sanction. AIMA agrees that this may be necessary in some areas; however, we caution against Community-level and national supervisors over-promising on supervision and gathering vast quantities of information for which there are no resources to interpret or no ability to use. This proposal risks moral hazard, as well as being burdensome and costly to hedge fund managers. AIMA is concerned that requirements to share large volumes of complex data may lull the market into a false sense of security and lower the level of due diligence that is currently being undertaken by market participants. Commission Communication Driving European Recovery The communication indicates that the Commission will publish proposals to implement parts of the High Level Group report we have commented on. As such, there is no need to repeat our specific comments. As more general comments, AIMA is mindful that the Commission will shortly publish a proposed Directive on alternative investment fund managers. This will include a wide range of provisions affecting hedge fund managers. We believe that it is important to avoid overlap and contradiction between this proposal and the proposals on supervision that will necessarily cover hedge fund managers. It is incontestable that the hedge fund industry should be properly regulated; however, the imposition of more regulation does not, of itself, bring about more effective regulation. Just as important as the need for enhancing regulatory processes is the need to preserve what works. Furthermore, AIMA notes the very ambitious timetable set out by the Commission in the 4 March communication. This is a concern. Putting in place a new European supervisory framework will not be easy. Ensuring that it is effective and efficient will be very challenging. The Commission will, no doubt, coordinate its thinking closely with national supervisors, the level 3 committees and the ECB - which will take time. All market participants appreciate the need for new supervisory mechanisms and the political pressure for outcomes, yet effective supervision and Europe s financial stability will not be served by hasty policy-making.

5 We thank the Commission for consulting with industry participants on the creation of its financial supervision package and we urge the Commission to continue to do so throughout this process and the creation of its proposed AIF Directive. The Commission s drive for regulatory reform coupled with the wealth of experience and knowledge within the industry could lead to the formation of a regulatory regime that is appropriate, easily implemented and able to endure and promote long-term financial stability. Yours sincerely Florence Lombard Executive Director, AIMA Tel: +44 (0) Fax: +44 (0) info@aima.org Internet: