FSA worried over excessive EU rules while firm on proportionate solution for hedge fund pay

UK regulator worried heavy handed rules will drive hedge funds out of Europe, depriving supervisors of information on their European activities

Financial Services Authority building

The UK Financial Services Authority (FSA) has warned that the European Union's attempts at "misguided" regulation could drive hedge funds out of Europe and wants a "proportional" solution to pay.

While it "might be possible for a hedge fund or a group of them to become systemic or to have a disruptive effect in markets, the FSA has "taken steps in the UK to address these concerns by gathering extensive information from both hedge fund managers and their prime brokers, in order to assess the risks of potential systemic presence and to mitigate them," reported Dan Waters, director, conduct risk, and asset management sector leader at the UK regulator.

He said there was a "need for regulators to be able to gather direct information about the trading and market footprint of hedge funds to see the development of a systemic presence of a fund or group of funds in a market including the levels of leverage that are involved." The extent and nature of funding counterparty exposures also needed to be monitor, noted Waters.

With this kind of information regulators would "have powers to tackle excessive leverage as well as practices which are potentially abusive in markets," he added.

waters-dan-fsa-uk"The far greater risk - and it is a real one - is that misguided European regulation of hedge funds drives them out of Europe, depriving European regulators of both the information we now have about their activities in European markets and the regulatory power to curb abuses, while these funds continue to invest in European markets," declared Waters. He was speaking in London at a conference organised by the Alternative Asset Management Association (Aima).

Waters also expressed concern over another type of "arbitrage" which he said could come from investment banks trying "to avoid the remuneration requirements applying to their staff by setting up separate structures to handle speculative trading activities".

On the subject of pay covered by the proposed implementation of the EU capital requirements directive's (CRD) remuneration rules which would affect banking and asset management, Waters said "there are circumstances in which their [hedge fund] remuneration could raise important regulatory concerns."

He continued: "Potential distortions arising from the ‘option like payoff' of performance fees, excessive co-investment or over reliance on ad valorem fees are well documented, particularly for hedge funds."

He pointed out that the concept of a link between the investment period and the fund manager's remuneration had found its way into recent drafts of the alternative investment fund managers (AIFM) directive, which he said the FSA considered to be "sensibly drafted" and "a reasonable place" for it to be mentioned as it was "more effectively tailored to the structures and operations of asset management firms and their funds and the real risks to investor protection that inappropriate remuneration structures might create."

AIFM, however, "rather unhelpfully contained a great deal of detail" but the remuneration requirements are covered by a general requirement of proportionality. "This principle is expressed in similar terms to the CRD, but the population of firms caught by the AIFM directive is narrower. This may have implications for how we will need to apply proportionality under the directive," said Waters.

He confirmed the FS intended to "engage more intensively" with the asset management industry over a consultation on CRD ending on October 8.

He said the FSA thought an important factor contained in CRD was the extent the tolerated risk of a fund results in a systemic presence in the market and "whether the risks arising from such a presence could be effectively dealt with through the use of macro prudential tools".

The approach of the FSA would reflect "our general characterisation that most asset managers do not currently have a systemic presence in the market through the funds that they manage," confirmed Waters.

"We do not propose a rigid approach to those elements of the CRD remuneration principles that are relevant in the design of remuneration structures for asset managers. Instead we have proposed that some elements of the code remuneration are applied proportionately and in some cases on a comply or explain basis. Such elements include the nature of remuneration payment, deferral of performance related remuneration, such as bonuses, and performance adjustment of those awards," he concluded.

Waters also noted the AIFM directive will propose a revision to the Ucits directive which will also contain provision on remuneration after a deal has been struck on the more controversial and contentious AIFM rules.

Both directives are likely to have guidelines issued by the European Securities and Markets Authority (Esma), a body which is yet to set up. Waters said Esma should design guidelines for asset managers that do not "create distortions betweens similar firms operating in the sector".

Read more articles like this one at Hedge Funds Review

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