Regulating AIFs: Power Politics in a Post-Crisis World

8/14/2019 Regulating AIFs: Power Politics in a Post-Crisis World

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P o l i t i c a l S c i e n c e 1 2 2 A : P o l i t i c s o f E u r o p e a n I n t e g r a t i o n

P r o f e s s o r J . N i c h o l a s Z i e g l e r & G S I B a r t W a t s o n

MichaelSinanianSincethefinancialmeltdownof2008,themandatetore-regulatethefinancialindustryhas

beenpracticallyself-evident.Whiledifficulttoimplicatedirectlyinthecrisis,theworldof

alternativeinvestmentfunds(AIFs)havecomeunderpolicymakerstargetsaswell.Politicalpowerstructuresonthenational,regional,andgloballevelwiththeirownindividual

preferencesforeconomicandpoliticalorganizationhavespurredanintensedebatearound

howregulationofAIFswilltakeplace.Bycarefullyevaluatingtherelevanteventsin2009,a

modelemergesthatexplainshowallthevariousactorsnation-states,politicalparties,the

industryanditsinterestgroupsinteractwithoneanotherandsharepowerinan

increasinglyglobalandinter-dependentworld.

Universit ofCalifornia,Berke

Fall 09

RegulatingAIFs:PowerPoliticsinaPost-CrisisWorld


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TableofContents

Introduction.................................................................................................................3

HistoricalBackground ..................................................................................................4

PoliticalActors.............................................................................................................8

RegulatoryProposalsCompared ................................................................................11

PoliticalDynamics ......................................................................................................14

FutureTrajectories.....................................................................................................18

Notes .........................................................................................................................21


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Introduction

TheEuropeanCommissionerofInternalMarketandServicesCharlie

McCreevysaiditbestwhenheattributedthecauseoftheglobalfinancialcrisistoa

combinationofoverlylaxmonetarypolicyandmacroeconomicimbalances.1There

isnoquestionthatunusuallylowinterestratesmaintainedbytheU.S.Federal

Reserveandothercentralbanksledtoaninfluxofinexpensivecapital,whichbanks

feltfreetoplacemassivelyleveragedbetswiththatultimatelyledtotheirown

demise.Inthatstory,theculpritswereeasilyidentifiable,andintheaftermath,the

mandatetoregulatethemseemedtobeself-evident.However,othereventsthat

occurredsimultaneouslynamelytheuncoveringofthegiantPonzischemerunby

BernardMadoffandtheinsidertradingscandaloftheGalleonGroupimplicated

anothersectorofthefinancialindustry:alternativeinvestmentfunds(AIFs),which

comprisechieflyofhedgefundsandprivateequityfirms.Thereislittletono

evidencethatdirectlyimplicatesthesefirmsincausingthecrisis,yettheyarenow

morethanevercomingunderthecrosshairsofregulatorsaroundtheglobe.

Sinceearly2009,afuryofregulatoryproposalsandassociatedpolicy

debateswhichhavesoughttoregulatethesefirmsthroughexistinginstitutionsor

possiblynewonescreatedspecificallyinresponsetothecrisishaveoccurredboth

withinandamongtheUS,theUK,andtheEuropeanUnion.Theoverwhelming

discoursethathastakenplacebegsseveralquestionswhoseanswerscouldfurther

thestudyofinternationallycoordinatedpolicymakinganditseffectivenessaswell

asgranderexperimentsinpoliticalorganizationsuchasEuropeanintegration.


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Thesequestionsinclude:whyarethesefirmsbeingtargetedforregulation

despitescantevidencethatcausallyimplicatesthem?Whataretheproposalsthat

seektoregulatethemandhowdotheydifferamongthevariouspoliticalactorsthat

areproposingthem?Howaretheseproposalsbeingcoordinatedwithinnation-

statesandamongthemandtowhatdegreeofcontentiondotheyface?Howwill

theseproposalsaffecttheindustry,ordinarycitizens,nation-states,andthe

relationsandpoliticalpowerstructuresbetweenthosestates?Finally,what

predictionscanbemadeaboutthefutureinstitutionalstructureofregulationandits

efficacy?Thispaperwillseektoaddressallthesequestions,focusingspecificallyon

theeventsthathavetakenplacethroughout2009andwithintheframeworkof

internationalrelationsandEuropeanintegration.

HistoricalBackground

Whatarehedgefundsandprivateequityfirmsandhowhavetheythusfarfitintotheregulatory

landscape?

Hedgefundsandprivateequityfirmsfallunderthelargercategoryoffinance

knownasalternativeinvestments,whicharedistinctfromtraditionalinvestments

suchasstocks,bonds,orcurrency.Thesefirmsusedifferentinvestmentstrategies

andtechniquestoprovidetheirinvestorswithpositivereturns,whichhave

increasinglyledthemtocommandgreaterrespectandinfluencewithinthe

industry.Onlyafewimportantfactorsgivethesefirmstheirperceivedadvantages

anddistinguishthemfromtraditionalinvestmentfirms:theyrelyonradically

differentinvestmentstrategies,theyarefarmoreexclusiveandcatertoonlya

handfulofinvestors,andtheytendtofalloutsidecertainregulatoryconstraints.


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Firstly,thesefirmsutilizeinvestmentstrategiesthattraditionalhousesdo

notemploy.Often,hedgefundswillengageinshort-sellingsecurities,trading

derivatives,andincreasedleveragetorealizepositivereturns.2Theseoptionsare

opentothembecausetheytendtofalloutsidetheregulationsthatgovern

traditionalinvestmenthouses.3Notonlydoesthisallowthemtoengageinriskier

investmentstrategies,italsoremovesthecostlyoverheadofonerouslegaland

compliancefees.Thepaystructureofthefirmalsoremovescomplexcommission-

basedcompensationschemesandinsteadcreatesahighlyincentivizedsystemof

performancefeesthatallowfundmanagerstotakehomeincomeonlyiftheyve

realizedpositivereturnsfortheirinvestors.

Similartohedgefunds,privateequityfirmsarealsousuallyexemptfrom

regulatoryconstraintsbasedontheirdifferentmodelofinvesting.Thesefirms

investinassetsthatarenotpubliclytradedontransparentexchanges,suchas

investingcapitalprivatelyinothercompanies.4

Bothhedgefundsandprivateequityfirmsare,bynature,notlistedonpublic

exchangesoropentosmallinvestors.Instead,theyallowaccesstoonlyaselect

groupofwealthierinvestors,oftenknownasinstitutionalinvestorswhoareableto

poolandinvestsubstantialsumsofmoneytotakebetteradvantageofthesefirms

organizationalstructuresandinvestmentstrategies.5

Despitebeinguniqueinmanyways,thesefirmshavenotentirelyevaded

regulatoryattempts.IntheUnitedStates,anattempttoregulateAIFswasmadeby

theSecuritiesandExchangeCommission(SEC)in2004,whenthegrowing

proliferationofhedgefundsbothexposedseveralordinaryandofteninsufficiently


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regulatoryumbrellaandfailingtoharmonizethosefundsthathadcomeunder

supervision.9Totheircredit,theyhavemanagedtoregistermosthedgefund

managerswiththeproperauthoritiesandsubjectthemtoinformation

requirements.8However,whiletheymayhaveresultedingreatercompetition

betweenfirmsacrossEUmember-states,theyhaveactuallyledtoashiftintrading

fromregulatedsecuritiestounregulatedover-the-counter(OTC)broker-dealer

venueswhere,substantialunregulateddarkpoolsofliquidityhavebuiltup.9

Additionally,notallAIFsbecameharmonizedacrosstheEU,andtheseoriginal

effortswereperceivedasineffectualasearlyas2006. 10Thecrisisactedasan

accelerantforpolicymakers,withthecollapseofLehmanBrothershighlightingthe

potentialdisasterofshort-sellingtechniques(whichmostAIFsengagein).11

Inthepost-crisisworld,theexistingregulatoryattemptsofthesethree

politiesweredeemedinsufficient,andreportsthatoutlinedthefuturedirectionof

AIFregulationwereissuedthroughout2009bythesegovernments.TheTurner

ReviewwasreleasedbytheUKsFinancialServicesAuthority(FSA),andunderthe

leadershipofAdairTurner,recommendedseveralregulatoryproposals.TheEU

releasedtheDeLarosiereReportsoonafter,authoredbyacommitteeofInternal

MarketCommissiondirectorates-general.OnJune17th,theUSTreasury

Department,undertheleadershipofTimothyGeithner,releasedtheirregulatory

proposalsfoundwithintheNewFoundationreport.Inadditiontothese

governmentwhitepapers,theGroupofTwentyFinanceMinistersandCentralBank

Governors(G-20)witnessedunprecedentedglobalagreementsonhedgefund

regulationandleverage-informationdisclosurethatwouldsubjectthesefirmsto


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effectiveriskmanagement.TheG-20summitinLondonwasafeatofglobal

governancethatprovidedalooseframeworkforpolicymakerstobemindfulofas

theyattemptedtore-regulatetheirindividualcountriesfinanceindustries.12

Thesenationalandsupranationalreviewsweretheimpetusbehindthe

policydiscoursethathastakenplacethroughouttheyear,andhaveconsiderably

shapedthepost-crisisdebate,definingregulationthatmaybeeithertoointrusive

ortoopassiveandgenerallysettingthegloballyrespectedperimetersofthedebate

byallactors.

PoliticalActors

Whoaretheindividuals,organizations,andgovernmentsthatareshapingthecurrentglobaldiscourse

onAIFregulation?

Althoughmanymembersoftheinternationalcommunityarenowreviewing

theircurrentregulatorysystemsandproposingoverhauls,thescopeofthispaperis

limitedtotheUS,theUK,andtheEU.Thegovernmentsofthesepolitiesarethe

primaryactors,aswellastheEUmember-states.

IntheUS,themainpoliticalactorsarethemembersofthelegislature,to

whichthecurrentadministrationhasassigneddelegatedmostoftheregulatory

mandateto.WhilenopoliticalpartyintheUSdeniestheurgencyofnewfinancial

regulations,theRepublicanpartyhassupportedthoseproposalswhichadvocate

minimalregulationwhiletheDemocraticpartyhasgenerallysupportedmuch

tougherlegislation.Inparticular,theDemocraticrepresentativesBarneyFrankand

ChristopherDodd,bothofwhomsitontheHouseFinancialServicesCommittee,

havebeenthedrivingforcebehindanynewregulatoryproposal.Alongwith


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RepresentativePaulKanjorskiwhoalsositsontheFinancialCommitteeandUS

TreasurySecretaryTimothyGeithner,thesearethemainpoliticalactorswithinthe

USgovernmentwhohavethepoliticalcapitalnecessarytomobilizearegulatory

overhaul.TheothermainactorsfromtheUSincludetheAIFindustryandits

lobby/interestgroups.

IntheUK,themainpoliticalactorsarescatteredthroughoutvarious

governmentalinstitutions,presentingamuchmorefragmentedlandscapethanthat

foundintheUS.WithinParliament,thesituationmuchmorecloselyresemblesthe

US,withallpartiesacceptingtheneedforfinancialregulation,butdisagreeingon

themechanismsandthedegreeofaction.TheLabourpartyhastakenapositionthat

correspondsroughlywiththatoftheDemocratsintheUS,urgingasmuch

regulationasispoliticallyfeasible.TheConservativeshavemirroredthe

RepublicansintheUS,acknowledgingtheneedforreformbutalwaysinsistingon

theleastactionpossible.Theirvariousproposalsalsodifferinthedegreesofpower

theyassigntoregulatoryinstitutions,withLabourpreferringtobolstertheFSA

whiletheConservativesaresupportiveofamuchstrongerBankofEngland.

Simultaneously,theheadoftheFSA,aself-describedtechnocratknownas

AdairTurner,hasbeenaloudcriticofthefinancialindustryandhascalledfor

greaterregulation.TheindustryandtheConservativeshavedespisedhistenureas

FSAchair.TheMayorofLondon,theConservativeBorisJohnson,hasalsobeenan

influentialvoice,flyingtoBrusselsonmorethanoneoccasiontovoicehis

disapprovalofEUregulatoryattemptsthatwouldstifletheCityofLondon.Hisrole

asapoliticalactorillustrateshowglobaltheregulatorydebatehasbecome,ashe


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representstheconstituentsofatrulyglobalcity.Furthermuddlingthepictureis

theinfluenceoftwoLabourpoliticians:LordPeterMandelson,theUKSecretaryof

State,andtheHMTreasurychairAlistairDarling(alsoknownastheChancellorof

theExchequer).Theirstatementsanddiplomaticactionshaveplayedakeyrolein

theUK-EUdiscourse.

RegardlessofhowinfluentialanyoftheUKgovernmentactorsmaybe,the

industryanditslobbygroupshavespurredsomeofthegreatestactivity,sincethe

CityofLondonishometoaflourishingAIFindustry,amongthelargestinthe

world.13Theyreinvolvementintheregulatorydebatehasthoroughlyshaped

proposals.

IntheEU,thepoliticalstructureanditsactorsaremuchmorediverse,with

nearlyeverycomponentofthesystemparticipatinginsomeform.TheEuropean

CommissionhastakenthemoststridentroleinregulationthroughitsInternal

MarketandServicesCommissionheadedbyCharlieMcCreevy.TheCouncilof

Ministers,chairedbytherotatingpresidencyofSwedenduringthetimeofthese

proposals,hasalsoplayedacrucialfactorinhowtheregulationshavebeenshaped.

TheEuropeanParliament(EP)hasalsobeenacentralactor,withtheSocialistParty

(PES)havingtheloudestvoiceincallsforregulation.TheEPsstudiesandreports

havealsobeeninstrumentalinshapingtheEUsregulatoryproposalsoutsideof

party-influencedpoliticalagendas.

InadditiontotheEUscomponentinstitutions,themember-statesthat

belongtotheUnion,suchasFranceandGermany,andtheirrespectiveministers

andheadsofstate,havealsoplayedapivotalroleinregulatoryattempts.The


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variousformsofcapitalismtheyembodyhaveclasheddirectlywiththatoftheUK

andtheUSwhenattemptingtocoordinateregulatorymeasures.Countriesoutside

thebloc,notablySwitzerland,haveindirectlyinfluencedthepoliticaldiscourse.

Whiletheyhavenotparticipatedindraftingregulatoryproposals,theirstatusasan

internationaltax-havenandaterritoryfallingoutsideofEUregulationshasmade

globalnegotiationsdifficult.Lastly,theAIFindustryinthecontinentdoesnot

representasubstantialshareofthemarket,andhavethusnotbeeninfluentialinthe

policydialogue.

RegulatoryProposalsCompared

Whatkindsofregulatoryproposalshavebeendraftedandwherehavetheycomeintoconflictwithone

another?

Thepointoforiginationfor2009seffortshasbeentheEUsDeLarosiere

Report,issuedbytheEUsInternalMarketandServicesCommission.Inaspeech

madeonFebruary26th,theCommissionshead,CharlieMcCreevyoutlinedwhere

AIFsfitintothecrisisanditsremedies,andspecificallycitedthemaseasy

scapegoatsformoredeep-rootedproblems,whichwerenotcentraltothecrisis.14

HefurtherexplainedquotingtheDeLarosiereReportthattheroleofhedge

fundshaslargelybeenlimitedtoatransmissionfunction,notablythroughmassive

sellingofsharesandshort-sellingtransactions.15Addressingprivateequityfirms,

hereiteratedthataspartoftheAIFssectortheyhavenotcausedthefinancialcrisis,

butstillpresentedaregulatorychallenge,notingthattherewereconcernsabout

howprivateequityfundsmanagetheirrelationswithstakeholdersincompanies

otherinvestors,work-forceandcivilsocietyatlarge.Afundamentalpoint


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McCreevywaskeenonmakingwasthathedgefundsandprivateequityfirms

thoughbothclassifiedasAIFswereinherentlydifferentinstitutionsthatrequired

differentregulatoryframeworks.Indeed,thesesentimentsweresoonsharedbythe

industryatlarge,andthisbecameoneoftheearliestpointsofcontention:aone-

size-fits-all-modelversusamoreindustry-specificapproach.16

TheCommissionerconcludedthatAIFswerealreadysubjecttoregistration

andoversightatthenationallevel,andtosaythattheywerecompletely

unregulatedinEuropewouldbeincorrect.Hefurtheraddedthattheinvestors

workingforhedgefundsandprivateequityfirmswerehighlytrainedand

experienced,requiringasofterlevelofregulation.17McCreevyssolutionwasthento

limittheflowofcreditatsource,soastoestablishafirstlineofdefenseagainst

dangerouslyhighlevelsofleverageinhedgefundsorexcessivelendingtoprivate

equityfirmsthatwouldencourageoverly-riskyinvestingpractices.Thekeywasto

keepthetaprunning,buttoensurethatfirmsmanagedtheirexposures.If

policymakersandregulatorsbelievedthattargetingAIFswouldsomehowregulate

thegreaterfinancialsystem,theywouldbedeeplydisappointed.18Shortlyafter

theserecommendationsweremade,theEuropeanCommissionlaunchedthedraft

oftheAlternativeInvestmentFundManagersdirective(AIFM).

Theindustrythenattackedthesedirectives,withtradeassociationsinstead

proposingtheirownsolution:aself-regulatorycodeofconductthatwouldgointo

forcewithinoneyear.19ThePESpromptlydismissedsuchproposalsas

unacceptable.20Theindustrylashedbackagain,claimingthatthedraftwasa

politicalpowerplaytosecureshort-termelectoralpointsforthethen-upcoming


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Parliamentaryelection.ThisdidnotthwartthePES,whoassertedinaletterto

EuropeanCommissionPresidentJoseBarrosothatthedraftwasnotevenstrong

enoughinitscurrentform,arguingthattheproposalscouldeasilybecircumvented

throughloopholes.21SomeoftheloopholescitedbythePESwereinfactreal

vulnerabilitiesintheAIFMdirective,asseveralindustryinsidershavethemselves

pointedout.22Theindustryfurtherarguedthatnotonlywasthereinsufficient

evidencetoprovethattheAIFMdirectivewouldprotectmoreinvestorsand

consumers,butthatthePESwasusingtheAIFindustrytodealwithemployee

rightsorsocial-policydrivennationaltaxrules.23Theysubsequentlycalledfora

wide-rangingimpactassessment,extendingtotheportfoliocompanies.23

ThisimpactassessmentwaseventuallyconductedbytheEuropean

Parliament,whichconcludedthattheAIFMdirectiveinitsoriginalformwaspoorly

constructed,ill-focusedandpremature.24Thedebatecametoaheadwhenafewof

theUKslargesthedgefundsthreatenedtorelocatelargeportionsoftheir

operationstoSwitzerland,whichwouldfalloutsideanyproposedEUregulations,

includingtheAIFMdirective.TheSwedishrotatingpresidencyoftheCouncilof

Ministersthenofferedacompromiseonthedraftthatwouldappeaseboththe

industryandpolicymakers.TheirnewrevisionfeaturedacurbonAIFmanagers

pay,borrowinglimits,andtherestrictionofoperationsbetweenEUandnon-EU

domiciledfunds.25Inspiteofthis,investorslargelywelcomedtheserevisions.26

Intermsofinstitutionbuilding,proposalsintheEUhavecenteredon

creatingaEurope-wideboardtomonitorsystemicrisk.IntheUK,thePrime

MinisterGordonBrownandhisLabourgovernmentarepushingtomaintainthe


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statusquoofthetripartitesystemestablishedoveradecadeago,whichsplitsthe

regulatorytaskbetweentheBankofEngland,theTreasury,andtheFinancial

ServicesAuthority.27IntheUS,theFrank-Doddproposalhaspushedforthabody

knownastheConsumerFinancialProtectionAgency(CFPA)thatwouldreplace

severalolder,seeminglyineffectiveregulatorybodiessuchastheOfficeofThrift

Supervision.Thatbodywouldrequireregistrationforhedgefundsandcentral

clearingforderivativessimilartotheEuropeansystem.

ThereisalsoatransatlanticconsensusthathasemergedsinceAugust2009

whichfocusesonstandardizingOTCproductsandrapidlyclearingthemthrough

centralclearinghouses,buildingcentraldatarepositoriestoenablesupervisorsto

quicklyidentifyareasofriskinthesystem,andtoestablishguidelinesforbilateral

clearingincaseswherestandardizedCCPclearingmaynotbeappropriate. 28These

stepsarebeingtakeninresponsetothegrowingconsensusthatOTCderivative

productsareessentiallyheretostay,despiteinvestorssuchasGeorgeSorosofthe

Quantumhedgefundcallingfortheirimmediatefreezing.28

PoliticalDynamics

Whatsortoffrictionscanbeidentifiedthroughoutthepolicydiscourseandhowhavetheyledto

compromiseorpoliticalvictoriesorlosses?

Thereareseveralkeytensionsthathavesurfacedsincetheseregulatory

proposalswerelaunched.Chiefamongthesetensionsincludethosebetween

politiciansandtheindustry,aswellasbetweenmember-statesandtheir

governments.Mostinterestingly,however,istheobservedphenomenonofa


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strengtheningglobalactionsystemthatseemsfromacursoryglancetobemore

effectivethannationalorregionalmechanisms.

Initially,thecrisiswasdefinedbyindustryleaderssquaringoffagainst

EuropeanParliamentariansorCommissioners.Giventhelackofdirectempirical

evidenceinthetrueriskposedbyAIFs,itisclearthatpoliticianshaveinfactseized

auniqueopportunityprovidedbymoreunscrupulousbankinginstitutionstoalso

regulatetheunpopularalternativeinvestmentssector.29Thiswasevidentinthe

rushedlaunchingoftheEuropeanAIFMdirective,whicheventheEuropean

Parliamentderidedaspoorlythought-out.Onlyifpolicymakerswereseekingtotake

advantageofsomesortofpoliticalmomentumwouldsuchhalf-wittederrorsbe

made.TheSwedishcompromiseinthereviseddraftmirroredtheG-20sproposals

onbankremuneration,whichhighlightstwomajorpoints.30

First,Europeanregulatorsareunawareoftheuniqueremunerationsystem

employedbyAIFs,whichrelyonasystemfardifferentfromthatoftraditionalbanks

duetothecomplexpartnership-structureofthesefunds.31Onereasonsuchpay

curbsareneverthelessconsideredisbecauseregulatorsrefusetobelievethatAIFs

dontcontributetosystemicrisk.32Thisbringstolightthepoliticallymotivated

natureoftheSwedishrevisions.TheAIFindustrylobbiedtoohardagainstthe

originaldraftoftheAIFMdirectiveandnowfacethetideofpublicopinionturning

againstthem.29Itwouldseemthen,thattheAIFindustryandfinancialindustries

ingeneralhavelargelylosttheirpoliticalcapitalsincethecrisisunfolded.Their

interestsarenolongerofsupremeimportance,despitethefactthattheydocoincide

withaprosperousEurope.33


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Second,theG-20hasbecomeahighlyinfluentialpoliticalforce,onethatmost

nationalandregionalauthoritiesnowlooktobasetheirregulatoryproposalson.

Thisseemstosupersedeanyinternalnationaldebatesandviewpointsandisa

remarkablephenomenonforinternationalrelations.Asevidenceofthisgreat

transformationinpoliticalpowerstructures,USSecretaryofTreasuryTimothy

GeithnersaidoftheFinancialStabilityBoard(FSB)whichtheG-20established,that

itisthefourthpillarofthemodernglobaleconomy,inconjunctionwiththe

InternationalMonetaryFund,theWorldBank,andtheWorldTradeOrganization.34

DespitetheseimportantimplicationsoftheSwedishrevision,itshouldalso

benotedthatthedraftAIFMdirectivemovesawayfromtheone-size-fits-allmodel,

whichfailedtodistinguishbetweenvariousAIFinstitutionsandhadbeenwidely

criticizedbyalmostallactors.29ThiswouldpleasetheAIFindustry,inadditionto

theotherprovisionthatbarstheEuropeanCommissionfromsettinglimitson

leveragelevelsforfundmanagers.29

Thefinalpoliticaldynamicthatshouldbeexploredisthatofcompeting

varietiesofcapitalismfoundwithintheEUthataredistinctlyshapingthepolicy

discourse.ArecentanalysisbytheGersonLehrmanGroup(GLG)apubliclyowned

AIFcapturedtheproblemposedbythesecompetingvarietiesofcapitalismwhen

itstated,ItiseasyforotherEUstatestoproposepopulistchangewhentheyhave

nodomesticbusinesstolose.35Tobesure,countrieslikeFrancethatarebasedona

state-ledeconomyorGermany,whichisbasedonacoordinatedeconomy,donot

havelargeAIFsectorsandwouldtruthfullybebarelyaffectedbyanyproposed

regulations.Thisclashesheadonwiththederegulated,market-drivenvarietyof


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capitalismfoundintheUK.Compoundingthisstarkdifferenceinpolitical-economy

isthesimplefactthatAIFsareahugeportionofthecountrysfinancialindustry,

withtheCityofLondonbothageographicandcolloquialtermthatencompasses

thenationsfinancialindustryaccountingforroughly9%oftheUKsGDP.36This

hasbeenoneoftheprimaryforcesbehindtheUKscriticalresponsetowardEU

regulatoryproposals.Despitethis,thecountryhasindeedmadesignificantsteps

towardsenactingregulationthatmirrorsG-20attempts.37Itcouldverywellbethat

theUSwithitssimilarunregulated,market-drivenvarietyofcapitalismisalso

onboardwiththoseglobalattempts,butregardless,itissignificanttothispaper

thatregionalpoweristakingabackseattonotnational,butratherwholly

internationalpowerarrangements.

Thisbegsthequestion:isregionalpowerdoomedtobeaweakintermediate

forceinarranginginternationalagreementsonimportantpolicyissues,stuck

betweenthedichotomyofnation-statesandinternationalinstitutionsandsummits?

ThecaseofSwitzerlandprovidesapossibleanswer,atleastwithinthecontextof

alternativeinvestmentregulation.Asanon-EUmember,itofferstheopportunityto

avoidboththeproposedAIFMdirectiveanditsrulesgenerally,aswellastherecent

Swedishrevisionwhichenforcesremunerationlimitsonfundmanagers.38However,

thisadvantageisquicklysweptasidewhenotherregulatorycomponentsare

considered,namelythefactthatmarketingandtradingwithout-of-blocfundswill

beseverelyifnotentirelylimited.Therefore,completelyavoidingtheproposed

directiveslawsismoreorlessimpossible,unlesstheseAIFsweretoabandonover

500million(relativelywealthy)EuropeanUnioncitizens.39Thiswouldnotentirely


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ruleoutcertainfundswhounderthethreatoftheAIFMdirectivewishto

minimizeexposuretotheEUanditsonerousregulationsbyrelocatingcertain

personnelandoperationsthatarenotgermainetoEU-wideactivities.40Whilethere

maybeafewmobilepersonnelwhowouldbeabletorelocatefromLondonto

Geneva,themajorityofLondonAIFpersonnelaresimplytooadjustedtothe

lifestyleandwillnotmove.41This,combinedwiththepossibleinaccessibilityofthe

entireEUmarket,providessomereassurancetofirmbelieversofregionalpower,

alatheEuropeanUnion,thatitstillexertsconsiderableinfluenceinshaping

internationalpolicyagreements.

FutureTrajectories

Whatsortsoftrajectoriescanwechartforfutureregulatoryattemptsandwhataretheramificationsof

thosetrajectories?

Basedonthehistoricalbackgroundofthefinancialinstitutionsinquestion

andtheassociatedregulatorylandscape,aswellastheeventsofthefinancialcrisis

of2008andtheinternationalpolicyresponsethathasfollowedthroughout2009,a

fewprojectionscanbemadeaboutwhattoexpectin2010andbeyond.

Intermsofinternationalpolicymaking,itcancertainlybeexpectedthatall

themajorplayerstheUS,theUK,andtheEUwilloverhaultheirfinancial

regulatorystructures(mostlythroughlegislation).Theindustrywilllargelybe

subjecttothesenewmeasures,regardlessofanyformalresistanceeffortsthat

woulddemandotherwise.Mostimportantly,thenationalandregionalplayerswill

looktowardtheglobalstage,namelytheGroupof20,toformregulatorystructures

around.42


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TrulyglobalinstitutionssuchastheFinancialStabilityBoard(FSB),

comprisedofcentralbankersandfinancialregulators,whichhasalsobeen

broadenedtoincludethebigdevelopingcountries,will,takealeadrolein

coordinatingandmonitoringtougherfinancialregulationsandserve(alongwiththe

IMF)asanearly-warningsystemforemergingrisks.43Inadditiontoprovidingthe

structures,theG-20alsosetsthetimeframe:withtheendof2012settobethe

deadlineforadoptinganynewregulatorystandards.44

Indeed,2010willbeanunprecedentedyearformeasuringtheefficacyof

globalagreements.WithinjustthescopeofAIFregulation,itsalreadyobviousthat

politicalactorshavemovedbeyondpan-Europeanortransatlanticconsensuses,but

haveshiftedtheirfocustoaglobalconsensus.Hence,issueslikefinancialoverhaul

willbesubjecttothesamenegotiatingprinciplesasthatofestablishingaglobal

climateregime,whichwillcoincidentallyalsobetestedafterthefailuretoreach

legallybindingagreementsinCopenhagenattheendof2009.

IntermsoftheactualmechanismsofAIFregulation,itcanbeexpectedthat

policymakerswillchoosetocurbrisk-takingthroughfundmanagerspaypackets

ratherthanviarestrictionsonthewaytheyconductbusiness.45Thisisduetothe

post-crisispoliticallandscape,whereregulatorscannolongerstandtohavethese

financialinstitutionsfreetomanagetheirinvestmentswithoutanysupervisionof

risk.ThiscreatesavortexaroundwhichtheEuropeanregulatorydebaterevolves:

thepoliticaltrade-offbetweenriskandreturn.44Basedonthecurrentrealitiesof

nationalpolitical-economiesandtheguidingprinciplesofsupranationalstructures

(liketheEU)suchaseconomicintegrationandliberalization,itisunlikelythat


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regulatoryattemptswilldirectlyimposeleveragelimitsandotherspecific

constraints.46

Thiswindstheissuedowntooneotherregulatorypossibility:self-

regulationormarket-basedapproachestoregulation.TherecentnewsofApollo

ManagementaprivateequityfirmdecidingtolistwiththeNewYorkStock

Exchange(NYSE)offersthehopethatformerlyprice-opaqueandgenerally

unregulatedfirmsmayvoluntarilycomeunderadifferentregulatoryframework

thatwouldsubjectthemtoinformationreportingrequirementsandleverageratios

withoutrequiringanygovernmentintervention.47Infact,Apollojoinsafewother

largeprivateequityfirmsthathavemadethisswitch,notablytheBlackstoneGroup

in2007,anotherbuy-outfirm.46Additionally,KohlbergKravis&Roberts(KKR)as

wellastheCarlyleGrouptwootherprivateequitygiantsareplanningtoliston

theNYSEaswell,lendingfurthersupporttoself-regulatorypossibilities.46Aside

frommoreformalmarketactions,informalmechanismsshouldalsobeaccounted

forinanyanalysisoftheself-regulatedparadigm.Forexample,mostAIFsoperate

onperformancefeesthatinthefaceofheavylosseswouldbeclosetozero,

forcingthesefirmstoshutdown,andthisislargelywhathastakenplacesincethe

financialcrisiscametoaheadinthefallof2008.48Inresponsetosuchself-

regulatorypossibilities,itisimportantasacademicsandpolicymakerstoalways

assessthetrueneedforstrong,bureaucraticregulatoryinstitutions,butlike

virtuallyeveryonetraumatizedbythecrisis,itisdifficulttorecommendanypolicy

thatdoesnotincludesomesortofinstitutionaloversight.


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Notes

Introduction1CharlieMcCreevy(EuropeanCommissionerforInternalMarketandServices),

OpeningSpeech,ECConferenceonPrivateEquity&HedgeFunds,Brussels,26Feb.2009

HistoricalBackground2Themechanicsofthesestrategiesrevolvearoundtakingadvantageofvarious

pricedifferentialsbetweensecuritiesaswellasothermarketinefficienciesinwhatisknownasarbitrage.Therearedifferenttypesofarbitrage,includingfixed-

income,statistical,andequityarbitrage,althoughtheformerhaslargelyfallenoutof

favorwithAIFs.3Alternativeinvestmentfundshaveuniqueinstitutionalstructuresthatallowthem

tofalloutsidecertainregulations.Hedgefundsspecificallyarestructuredaslimitedpartnershipswhosegeneralpartnermanagesthefund,whiletheinvestorsremain

passiveandtakenopartinthefundsmanagementandstrategies.Thispartnership

structureallowsthefundtoofficiallyservelessthan15clients,eventhoughtheymanageseveralinvestorsassetsworthagreatsum.ThisthenbypassestheSECs

registrationrequirements.SeeHindy,GregoryJ."GuestArticle:HedgeFundManagerRegulation."HedgeFund.net.16Nov2009.HedgeFund.net,Web.15Dec

2009..

4Therearevarioustypesofprivateequityfirms,suchasleveragedbuy-outfirms,whichtakeacertainlevelofrisktobuycompaniesatalowpriceandsellatahigher

price,venturecapital,whichidentifyopportunitiesinthemarketandinvestin

companiesthatdevelopproductswhichcatertothoseopportunities(internet,dot

com,etc),entrepreneurship,andothermyriadprivatecompaniesthatwillgrow,develop,andreturnapositiveinvestment.

5Institutionalinvestorsareoftenorganizationssuchasbanks,insurancecompanies,

retirementorpensionfunds,hedgefunds,andmutualfundsandrarelybut

sometimesverywealthyindividuals.6ThecourtruledthattheSECsHedgeFundRulewasaninvalidinterpretationof

theInvestmentAdvisersActof1940,whichAIFshadbeenexemptedfrom.SeePhillipGoldstein,etal.v.SecuritiesandExchangeCommission,no.04-1434,United

StatesCourtofAppeals(fortheDistrictofColumbiaCircuit),23June2006.;

7MichaelSinanian,InternetChatInterviewwithAramSethian(HedgeFund

Analyst),13Dec2009


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8SeedeLarosiere,Jacques.EuropeanUnion.High-LevelGrouponFinancialSupervisionintheEUReport.Brussels:EU,2009.Web.15Dec2009.9McCreevyalsonotedinhisspeechthattheMiFIdwillbecomprehensively

reviewedtoaddressthegrowingissueofdarkpools.SeeCharlieMcCreevy(EuropeanCommissionerforInternalMarketandServices),Towardsanintegrated

approachtoregulationacrosstheEU,PublicAffairsIrelandConference

RegulatoryReformintheIrishEconomy,Dublin,18Sep.200910AnarticlebyKarelLannobringstoattentiontheEuropeanCommissionsplansto

regulatehedgefundsassomethingthathadbeenconsideredasearlyas2006.The

Commissionsnewdraftrulesaimtomakeallnon-harmonizedfundscomeunderoneunifiedregulatoryumbrella,ThisEU-wideumbrellawouldincorporatethe

rulesofexistingdirectiveslikeMiFIdandUCITSaswellasnewrulesfromanewdirectiveknownastheAlternativeInvestmentFundManagersdirective(AIFM)and

introduceasinglelicenseforsuchfunds.SeeLannoo,Karel."Bringinghedgefundsintotheregulatorymainstream."EuropeanCapitalMarketsInstitute.24.(2009);

11KarelLannooidentifiestheLehmanBrotherscollapsespecificallyasaloudsiren

thatwokeEuropeanregulatorsuptotheurgencyofregulatingAIFs.Thisiswhat

helpedspawntheAIFMdirectiveandthenewregulatoryproposalssuchasappropriateliquiditymanagement,segregationbetweenassetmanagementand

depositaryfunctions,andadditionalreportingrequirementsforhighly-leveragedfunds.However,Lannooarguesthattheseedsforsuchactionweresownmuch

earlier,whentheEUwashavingclearproblemswithharmonization(certainfund

productscouldonlybesoldtoretailinvestorsinsomememberstates,butnot

others)andofcourse,alsowantedAIFstodisclosetheiractivitiesandprovideleverage-information.

12TheG20outlinedthecreationoftheFinancialStabilityBoard(FSB),whichisa

proposalsimilartotheEUsEuropeanSystemicRiskBoard(ESRB),andthe

EuropeanCommissionhasaseatonthatboard.Thisisapositiveindicationinterms

ofglobalpoliticalcoordinationandmaybeoneofthegreateraccomplishmentsinthewholedebate.SeeCharlieMcCreevysTowardsanintegratedapproach

speech(citedinEndnote9)

PoliticalActors13Thereareabout450hedgefundsinLondon,orabout80%oftheEuropeantotal,managingacombined450billionpounds.UK-basedhedgefundsemployabout

10,000professionalsdirectly,and30,000othersindirectly,includingserviceproviderssuchaslawyersandaccountants.TradeassociationAIMA'sestimated

impacttotheindustryduetotheproposedregulationsisaround25billionpounds.

SeeMoya,Elena."HedgefundsfacelongEUregulationbattle."Guardian20Aug2009:n.pag.Web.15Dec2009.


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.;

RegulatoryProposalsCompared14Hedgefundsandprivateequityweretheposter-boysofthenewfinance.Theysurfedthewaveofabundantliquidityandcheapcredit.Theyareeasyscapegoats

formoredeep-rootedproblems.SeeCharlieMcCreevy(EuropeanCommissionerforInternalMarketandServices),OpeningSpeech,ECConferenceonPrivate

Equity&HedgeFunds,Brussels,26Feb.2009;15[Hedgefunds]canalsoaffectthewiderfinancialsystemthroughthedirect

effectsoftheirtradinginthemarketswheretheyhavebecomeimportantand

sometimesdominanttraders.SeeCharlieMcCreevysOpeningSpeechfromFebruary26,2009(citedinEndnote14)

16Burgess,Kate,MartinAmold,andSamJones."InvestorswelcomerevisedEUfundrules."FinancialTimes13Nov2009:n.pag.Web.15Dec2009.

.

17Membersoftheindustrycontentthatfirmsarewellawareoftheperformanceof

theiroperations.Iftheyperformpoorly,theiroperationwillshutdown.Thereare

severeconsequencesandpricestopayforpoorperformance.Unlikethetraditional

bankingsector,thereisnomoralhazardorbailoutoptionopentothesefirms.Thiskeepstheminline,echoingCommissionerMcCreevyssentiments.SeeInternetChatInterviewwithAramSethian(citedinEndnote7)

18DirectlycounteringCommissionerMcCreevysrecommendations,theSocialist

PartyintheEuropeanParliament(PES)releasedastatementsayingexcessivedebtfuelledbyprivateequityfundscontributestothedestabilizationofthefinancial

system.See"EUtotableprivateequityregulationbyendofApril."EurActiv27Feb

2009:15Dec2009..;

19ThesetradeassociationsincludetheEuropeanPrivateEquityandVentureCapitalAssociation(EVCA)andtheAlternativeInvestmentManagementAssociation

(AIMA).SeeSorkin,AndrewRoss."HedgeFundsAttackE.U.RegulationProposals."

TheNewYorkTimesDealbook.TheNewYorkTimes,24Apr2009.Web.16Dec2009..

20SeeEurActivsEUtotableprivateequityregulation(citedinEndnote18)

21SeeAndrewRossSorkinsHedgeFundsAttackE.U(citedinEndnote19)


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22Theindustryhadbraceditselfforregulationstobeimposedonfundswithassets

undermanagement(AUM)of250millioneurosormore.Instead,thedraftAIFMdirectiveproposeda100millioneurosormorelimit.Theindustrywasperplexedat

howfundswhoseAUMswereinthesub-100meurosrangecouldactuallyposea

systemicrisktothemarket.Additionally,industrysourceshaveconfirmedthatthedraftAIFMdirectivecouldeasilybecircumventedbythecreationofclonefunds

thatwouldfallbelowthe100meuroAUMlimitandstilloperateinthesamesectors.

Thiswouldintheeyesoftheindustrycompromisemarketefficiency,leavinginvestorstofacehighercostsfornoimprovementinmarketperformance.See

Yeadon,Ken."EUHedgeFundregulationproposalsandthelawofunintended

consequences."Hedgehogs.net.12May2009.Web.16Dec2009.

.

23Theindustry,criticizingthePESslettertoPresidentBarroso,contendsthat

withoutproperevidencedemonstratinghownewregulationswouldofferbetterprotection,thereisnonecessitytoclampdownonaverylargeandimportant

industrywhichfinancescompaniesemployingmillionsofpeople.SeeWitney,Simon,andSJBerwin."FurtherregulationofprivateequityinEurope."AltAssets:GlobalPrivateEquityNews&Research30Apr2009:16Dec2009.

.24"Fundmanagers'pay:Adefectivedirective." Economist19Nov2009:16Dec2009..

25"EUtobaralternativefundsoutsidebloc."EurActiv12Nov2009:16Dec2009.

.

26SeeKateBurgess,MartinAmold,andSamJonesInvestorswelcomerevisedEU

fundrules(citedinEndnote16)

27Plender,John."RespinningtheWeb."FinancialTimes21Jun2009:16Dec2009..

28CharlieMcCreevy(EuropeanCommissionerforInternalMarketandServices),DerivativesandRiskAllocation,DerivativesConferenceSpeakersDinner,

Brussels,24Sep.2009

PoliticalDynamics29"Fundmanagement:Paybacktime."Economist19Nov2009:16Dec2009.

.


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30Taylor,Paul."LobbyingEffortBackfiresforHedgeFunds."NewYorkTimes16Nov

2009:16Dec2009..

31

Thisisduetotheaforementionedsystemofperformancefees,whichfundmanagerscollectonlyiftheyrealizepositivereturnsontheirinvestments.

Economistarticle:2008,abadyearforthehedge-fundindustry,bonusesatthe

worstperformingfundsfellby26%.Inthecaseofprivate-equityfunds,managerstypicallyonlyearntheirperformancefee,orcarryitover,whentheinvestmentis

realized,sotheresnoconflictofinterest.

32Evenifthatweretrue,governmentsdidnotexplicitlyrescueAIFs.33ThatpartofthebusinessservicingEUclientswillcontinuetooperatewithintheEU.However,theEUandinparticulartheUK,riskslosingthebenefitsofmanagers

servicingtheirglobalbusinessfromLondon.Thatrepresentsaconsiderablepotentiallossofconsumerspendingaswellasbothdirectandindirecttax

revenues.See"WillthelastHedgeFundmanagertoleaveLondonpleaseturnoutthelights."GersonLehrmanGroup(GLG)News16Nov2009:n.pag.Web.16Dec

2009..34"TheG20summit:Regainingtheirbalance."Economist26Sep2009:16Dec2009..

35ItiseasyforotherEUstatestoproposepopulistchangewhentheyhavenodomesticbusinesstolose.SeeGersonLehrmanGroupsanalysisWillthelastHedge

fundmanagertoleave(citedinEndnote33)36TheMayorofLondon,BorisJohnson,hassaid,Iknowhowunpopularthese

bankersarebutneverforget,allyouwould-bebankerbashers,thattheleper

colonyintheCityofLondonproduces9percentofUKGDP.SeeEaglesham,Jean."TensionoverlineonCitycurbsgrows."FinancialTimes05Oct2009:16Dec2009.

.37TheUKproposalssupportthetransformationoftheFinancialServicesAuthority(FSA)intoabodythatwillhavepowerstoclawbackbankbonusesthatbreach

globallyagreedrulesonremunerationandforcehedgefundstoprovidedata.

Accordingtotherecentlyproposeddraftbanklaw,theFSAwillbestrengthened

withwhatthedocumentcallsinformationgatheringpowersthatwillextendtoAIFs,particularlyhedgefundswhereinformationisrelevanttofinancialstability.

ThismirrorstheFSBestablishedbytheG20.See"DraftUKbanklawgiveswatchdog

morepowers."EurActiv20Nov2009:16Dec2009.


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.38InadditiontothedraftAIFMdirectiveandtheSwedishpresidencycompromise

revisiontoit,itshouldbenotedthattaxesimposedbytheUKgovernmentontheCityofLondonareoneofthegreatestreasonspromptingthecallstomoveto

Switzerland.Industryanalystscontendthatthesenationally-imposedtaxesarea

greaterincentiveforAIFstoconsidermovingtoSwitzerlandthananyEUproposal.SeeGersonLehrmanGroupsanalysisWillthelastHedgefundmanagertoleave

(citedinEndnote33)

39SeeGersonLehrmanGroupsanalysisWillthelastHedgefundmanagertoleave(citedinEndnote33)

40TherecentcaseofBlueCrestCapitalManagementrelocatingnearly50employees

toGenevaillustratestheactualityofthisoption.SeeJones,Sam."BlueCresttorelocate50stafftoGeneva."FinancialTimes11Nov2009:16Dec2009.

.

41TherearetoomanypeopleinLondonwholikelivingthere,andareusedtothelifestyle,andwontmove,butthereareafewwhoaremobileandcanmove.These

fewwillrelocateifnecessary.SeeGersonLehrmanGroupsanalysisWillthelastHedgefundmanagertoleave(citedinEndnote33)

FutureTrajectories42ThisevidenceincludesthecommentsmadebyGeithner(discussedearlierinthe

paper),theEUsownESRBbeingbasedontheG20FSB,andtheUKsdraftbanklawwhichwillturntheFSAintoasystemicrisk-monitoringagencyliketheG20FSB.See

EurActivsDraftUKbanklawgiveswatchdogmorepowers(citedinEndnote37)

43SeeTheEconomistsTheG20Summit:Regainingtheirbalance(citedinEndnote

34)

44SeeTheEconomistsTheG20Summit:Regainingtheirbalance(citedinEndnote

34)

45SeePaulTaylorsLobbyingEffortBackfires(citedinEndnote30)46Asproofofthis,theSwedishrevisiontothedraftAIFMdirectiveremovesfromtheoriginalproposaltheabilityfortheEuropeanCommissiontoplaceleverage

limits.SeePresidencyoftheCounciloftheEuropeanUnion.ProposalforaDirective

oftheEuropeanParliamentandoftheCouncilonAlternativeInvestmentFund


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ManagersandamendingDirectives2004/39/ECand2009/.../EC-Presidency

compromiseproposal.Brussels:EU,2009.47Sender,Henry."ApollosetssightsonNYSElisting."FinancialTimes18Nov2009:

16Dec2009..

48Thebulkoftheirmoneycomesfromperformancefees,whichmeanstheyonlydowellwhentheirinvestorsprosper;in2008,abadyearforthehedge-fundindustry,

bonusesattheworst-performingfundsfellby26%.Inthecaseofprivate-equity

funds,managerstypicallyonlyearntheirperformancefee,orcarry,whenthe

investmentisrealised,sothereisnoconflictofinterest.SeeTheEconomistsFundmanagement:Paybacktime(citedinEndnote29)

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Regulating AIFs: Power Politics in a Post-Crisis World

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