Europe Warms to Modern Investments: Europeans Continue to Pour Their Retirement Funds into Managed Investment Schemes, but Managed Futures Are Getting Just a Small Slice, and Hedge Funds Find Themselves Back in the Regulatory Crosshairs after Winning Friends and Influencing Regulators in 2006

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This time last year, the European Union, with the exception of Germany, was drifting towards the "light touch" model of hedge fund oversight advocated by the United Kingdom's Financial Services Authority (FSA). Retail providers across the Continent were gingerly introducing currency derivatives into investment funds, albeit only for hedging purposes, because that's all that's permitted under the Continent's amended directives covering Undertakings for Collective Investment in Transferable Securities or UCITS.

These are European investment funds that meet standards of transparency, structure, and practice agreed upon by all EU member states and can be 'passported' into all member states without having to be approved by the local regulator.

European futures funds and hedge funds, on the other hand, must be structured as private placements and approved by each state in turn. Likewise, managed futures accounts can be marketed across the European Union when the minimum is [euro]50,000, on the assumption that people who can afford them have deep enough pockets to absorb the risk.

Before the subprime mortgage debacle, European regulators were talking of letting managed futures into pension schemes--and many still are, but their utterances have become background noise in the debate over the operational side of the over-the-counter (OTC) hedge fund industry, triggered after several small European banks went into receivership after finding themselves the shamed owners of bad American mortgage debt. Now even the FSA says sloppy controls by hedge fund operators put the system at risk.


With the bulk of European hedge funds domiciled offshore but distributed through London-regulated entities (see: "Location, location," page 65), the FSA has impacted more hedge funds than has any other regulator, and for a while most Continental regulators were following their lead.

In late 2006, for example, the EU Commission's Alternative Investments Experts Group (AIEG) had joined the global Counterparty Risk Management Policy Group (CRMPG) in declaring the hedge fund menace overblown. Both hailed the counterparty checks and balances developed under the auspices of the International Swaps and Derivatives Association (ISDA), as well as the FSA's light touch approach.

And as for the charge that hedge funds were abusing their ownership privileges by kicking around corporate managers, the decidedly un-hedge-fund-friendly European Parliament issued the following statement:

"Corporate managers are learning to value and exploit the feedback and strategic advice they receive from hedge fund managers; they rate the business acumen of hedge fund managers more highly than the classic (and often passive) institutional 'long-only' investor."

But critics like German Chancellor Angela Merkel and her finance minister, Peer Steinbruck, never bought into any of the arguments. Both conceded that the UK approach was a necessary component in the protection of unsophisticated retail investors, but they warned that it left the door open to systemic risk, while Steinbruck remained openly skeptical of their short-term motives as owners.

Both were pilloried by foes of overregulation, who zeroed in on Steinbruck's call for all hedge funds to be required to register their positions with the European Central Bank (ECB)--but Steinbruck himself has stated that such a step would only come about if the industry doesn't get its own house in order. All he's ever really said in absolute terms is that hedge funds should be forced to come up with a sort of National Futures Association (NFA) of hedge funds: a structured and transparent (if informal) self-regulatory entity answerable to European Union regulators.

But you can't really say the German view has been vindicated. The Bundesbank, for example, was right in warning of systemic risk related to the proliferation of credit default swaps, but their prescribed remedy was a call for hedge funds to be audited by ratings agencies--the same group now being investigated by U. …