Regulating Hedge Funds for Systemic Stability: The EU's Approach

Published date01 November 2015
Date01 November 2015
Regulating Hedge Funds for Systemic
Stability: The EUs Approach
Andrew Johnston*
Abstract: This article offers a critical appraisal of the way in which the EU regulates
hedge funds (HFs) in the Alternative Investment Fund Managers Directive (AIFM
Directive) and its proposal to regulate the repo markets from which they obtain much
of their leverage. It argues that the EUs scheme is not a radical departure from the
pre-crisis market liberalist approach and that its reliance on discretionary intervention is
misplaced because it does not take account of the fundamental uncertainty that
characterises nancial markets. The article outlines the operations of HFs and explores
the extent to which they pose a threat to systemic stability, paying particular attention
to the use of leverage by HFs. It explores the background to the AIFM Directive and
the post-crisis international consensus on nancial regulation and then evaluates the com-
plex division of responsibility for regulating HFs between the national and supranational
authorities. Finally, it discusses how HFs should be regulated. Drawing on the work of
Minsky, it argues that a leverage cap would have been more likely to prevent HFs contrib-
uting to systemic instability than the scheme adopted. Nor are the proposed rules on man-
datory haircutsin repo markets or the AIFM Directives rules on remuneration likely to
prevent HFs contributing to systemic instability.
I Introduction
This article explores the way the European Union regulates hedge funds (hereafter
HFs). Its main focus is on the Alternative Investment Fund Managers Directive (AIFM
and the recent EU proposal for a Regulation on Reporting and Transpar-
ency of Securities Financing Transactions (SFT Regulation).
The AIFM Directive
aims to regulate HFs by regulating their managers, whilst the purpose of the SFT Reg-
ulation is to create greater transparency in the securities nancing (or repo) market,
which will indirectly regulate HFs, because that market is the source of much of the le-
verage that HFs use.
I am grateful to Illka Harju, Trevor Pugh, Jay Cullen, Robert Burrell, the editor of the European Law Jour-
nal and the anonymous referees for helpful comments, critique and discussions relating to this article. All the
remaining errors are my own.
*School of Law, University of Shefeld, Shefeld, UK
Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Invest-
ment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No
1060/2009 and (EU) No 1095/2010 OJ L 174, of 01.07.2011, p. 173. Agreement was reached on the Di-
rective on 8 June 2011, and it came into force on 21 July 2011.
See Proposal for a Regulation of the European Parliament and of the Council on Reporting and Transpar-
ency of Securities Financing Transactions, COM (2014) 40 nal, of 29.01.2014, available at
European Law Journal, Vol. 21, No. 6, November 2015, pp. 758786.
© 2015 John Wiley & Sons Ltd., 9600 Garsington Road, Oxford, OX4 2DQ, UK
and 350 Main Street, Malden, MA 02148, USA
The articles main concern is to determine the extent to which European regulation
can full what is allegedly its main purpose, namely, ensuring that HFs are managed
so that they do not become sources of instability for the nancial system as a whole,
that is, systemic instability. HFs operate on the basis of leverage, that is, their invest-
ments are nanced not only by the capital contributed by their investors but also by
borrowed money that supplements that capital. Depending on the strategy pursued
by individual HF managers, those borrowings can range from one or two times to many
multiples of the funds capital.
The instruments discussed in this article recognise that HFsuse of leverage can result
in nancial instability. In particular, the AIFM Directive explicitly justies its regula-
tion of HF managers by reference to effective monitoring of systemic risk
and states
that HFsuse of leverage means that they may under certain conditionscontribute to
the build-up of systemic risk or disorderly markets.
Similarly, the SFT Regulation is
intended to enhance nancial stabilitythrough the imposition of uniform transparency
rules on the securities nancing transactions that, inter alia, provide HFs with much of
their leverage.
But does this acknowledgment of the risks inherent in the way HFs op-
erate translate into an effective regulatory framework?
Many argue that the two legal instruments considered in this article mark a paradig-
matic shift, a bold intervention that limits the economic freedom of HFs and that will
reduce the danger that HFs will pose a threat to systemic stability. In particular, it
has been claimed that there was a genuine willingness on the part of British political
and regulatory chiefs to engage in a quite fundamental reappraisal of the States role
and that the AIFM Directive is the product not only of political compromise but also
of a principled, intellectually-grounded move away from formerly orthodox beliefs in
the self-correcting effects of markets.
Other observers are more sceptical of whether
there has been a real change of heart on the part of the British authorities and instead
claim that the move away from the belief in self-regulating nancial markets results
from market-shapingMember States, such as France and Germany, prevailing over
market-makingMember States, such as the UK. This new balance of regulatory
power has partly affectednational regulatory approaches and the prevailing para-
digm in the EU, even though it does not amount to a fully-edged paradigm shift.
This article takes a rather different position. It shows that the assumption shared by
nancial economists and nancial regulators before the crisis, namely, that nancial
markets can, for the most part, be left to regulate themselves, still casts a long shadow
AIFM Directive, above n. 2, preamble, §88.
Ibid., preamble, §49.
See above n. 2, §§5 and 6.
E. Ferran, The Regulation of Hedge Funds and Private Equity: A Case Study in the Development of the
EUs Regulatory Response to the Financial Crisis,University of Cambridge Faculty of Law Working Paper
No 10/2011 (February 2011), available at,
at 17. Fioretos offers a similar appraisal of the regulatory regime drawn up by the G20 in 2009, which,
as will be shown next, strongly inuenced the AIFM Directive, claiming that it represents an important
shift in how the worlds large economies regulate the prudential risks associated with hedge funds. See
O. Fioretos, Capitalist Diversity and the International Regulation of Hedge Funds(2010) 17 Review of In-
ternational Political Economy 696723, at 700.
L. Quaglia, The Oldand NewPolitical Economy of Hedge Fund Regulation in the European Union
(2011) 34(4) West European Politics 66582, at 678
Regulating Hedge Funds for Systemic StabilityNovember 2015
© 2015 John Wiley & Sons Ltd. 759

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