Regulating AIFs: Power Politics in a Post-Crisis World
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Transcript of 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)