Compliance Gets Complicated

For many hedge fund industry participants and observers, 2010 is shaping up to be the Year of Compliance following rumblings from global financial regulators about cracking down on practices such as naked short selling, which helped bring about the credit crisis.

With the year now half over, that outlook has yet to fully materialize, due in no small part to US, UK and European regulators seemingly using different playbooks in their approaches to clamping down on the industry. This ongoing lack of regulatory coordination may have bought hedge fund managers some time in the short term, but those firms hoping to get a leg up in terms of enhancing their compliance infrastructures in anticipation of new requirements still lack a clear idea of just how limited or comprehensive any final regulatory regime will prove.

In the US, legislation to overhaul financial regulation, including rules affecting hedge fund managers as well as derivative instruments many of them trade, has yet to become enacted into law, and many of its provisions remain highly malleable.

In Europe, the regulatory situation has grown even more fragmented, with the UK maintaining its position that too strict an approach to hedge funds will drive the industry out of London, while the European Union is pushing for more rigorous new requirements.

The New York Times recently reported that over the objections of the US and UK, the EU approved rules requiring hedge funds, private equity shops and commodity fund managers to register with regulators and disclose details of their trading activities and positions; managers would also have to maintain capital reserves to cover risk.

In addition, the EU’s regulatory proposal would make it more difficult for fund managers to sell across the trade bloc, instead requiring firms to seek investors in individual European markets, nation by nation. US Treasury Secretary Timothy Geithner  warned that this move could prevent US fund managers from doing business in the EU.

The Alternative Investment Management Association (AIMA), a global hedge fund trade association, has unsurprisingly come out against the EU proposals, warning of detrimental effects on international trade and capital flows, as well as pension and insurance funds.

Whether or not these proposals become law, however, remains to be seen—expectations are that the more stringent EU regulations will be watered down before final adoption.

In the meantime, hedge fund managers eager to stay on top of their compliance requirements in order to focus on their core competencies can either anticipate high-level requirements around transparency and disclosure likely to be adopted by regulators across markets, or take a wait-and-see approach to avoid embarking on costly compliance infrastructure projects that may ultimately fail to meet new regulatory requirements. Perhaps the most prudent option would entail both tactics—any manager not yet taking steps to address issues around transparency and disclosure long demanded by investors and now regulators should think about other lines of work; regardless of what shape US and European hedge fund regulations will take, greater reporting requirements will constitute a key element of those rules. Ensuring one’s data capture and reporting capabilities can at least meet investor demands on a broad level is a good first step.

At the same time, managers can ill afford to undertake substantial new compliance projects in this economic climate without clear targets. Many in the industry were no doubt hoping for a more coordinated global regulatory effort given the evermore international nature of hedge fund management, but it appears that significant regional barriers—particularly between the UK and continental Europe—remain firmly in place. Until regulators either singly or collaboratively decide upon final rules for the industry, managers had best wait for firm details before setting out to meet more specific requirements.