Regulating Hedge Funds for Systemic Stability: The EU's Approach
DOI | http://doi.org/10.1111/eulj.12159 |
Published date | 01 November 2015 |
Date | 01 November 2015 |
Regulating Hedge Funds for Systemic
Stability: The EU’s 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 EU’s 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 financial 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 financial 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 ‘haircuts’in repo markets or the AIFM Directive’s 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
Directive)
11
and the recent EU proposal for a Regulation on Reporting and Transpar-
ency of Securities Financing Transactions (SFT Regulation).
22
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 financing (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 Sheffield, Sheffield, UK
1
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. 1–73. Agreement was reached on the Di-
rective on 8 June 2011, and it came into force on 21 July 2011.
2
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 final, of 29.01.2014, available at http://ec.eu-
ropa.eu/finance/general-policy/docs/shadow-banking/140129_proposal_en.pdf
European Law Journal, Vol. 21, No. 6, November 2015, pp. 758–786.
© 2015 John Wiley & Sons Ltd., 9600 Garsington Road, Oxford, OX4 2DQ, UK
and 350 Main Street, Malden, MA 02148, USA
The article’s main concern is to determine the extent to which European regulation
can fulfil what is allegedly its main purpose, namely, ensuring that HFs are managed
so that they do not become sources of instability for the financial system as a whole,
that is, systemic instability. HFs operate on the basis of leverage, that is, their invest-
ments are financed 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 fund’s capital.
The instruments discussed in this article recognise that HFs’use of leverage can result
in financial instability. In particular, the AIFM Directive explicitly justifies its regula-
tion of HF managers by reference to ‘effective monitoring of systemic risk’
3
and states
that HFs’use of leverage means that they may ‘under certain conditions…contribute to
the build-up of systemic risk or disorderly markets’.
4
Similarly, the SFT Regulation is
intended ‘to enhance financial stability’through the imposition of uniform transparency
rules on the securities financing transactions that, inter alia, provide HFs with much of
their leverage.
5
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 State’s 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’.
6
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 financial markets results
from ‘market-shaping’Member States, such as France and Germany, prevailing over
‘market-making’Member States, such as the UK. This new balance of regulatory
power has ‘partly affected…national regulatory approaches and the prevailing para-
digm in the EU’, even though it does not amount to ‘a fully-fledged paradigm shift’.
7
This article takes a rather different position. It shows that the assumption shared by
financial economists and financial regulators before the crisis, namely, that financial
markets can, for the most part, be left to regulate themselves, still casts a long shadow
3
AIFM Directive, above n. 2, preamble, §88.
4
Ibid., preamble, §49.
5
See above n. 2, §§5 and 6.
6
E. Ferran, ‘The Regulation of Hedge Funds and Private Equity: A Case Study in the Development of the
EU’s Regulatory Response to the Financial Crisis’,University of Cambridge Faculty of Law Working Paper
No 10/2011 (February 2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1762119,
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 influenced the AIFM Directive, claiming that it ‘represents an important
shift in how the world’s 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 696–723, at 700.
7
L. Quaglia, ‘The “Old”and “New”Political Economy of Hedge Fund Regulation in the European Union’
(2011) 34(4) West European Politics 665–82, at 678
Regulating Hedge Funds for Systemic StabilityNovember 2015
© 2015 John Wiley & Sons Ltd. 759
To continue reading
Request your trial