European Union Hedge Fund Regulation 101


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European Union Hedge Fund Regulation 101

  1. 1. EU Regulation 101 Guide to European Oversight of the Hedge Fund Industry Hedge Fund Fundamentals | March 2014
  2. 2. Introduction 2 Hedge funds play a vital role in helping a wide range of institutions – from pensions to endowments to non-profits – meet their financial obligations. In Europe, hedge funds oversee roughly $549 billion in assets, according to a recent report by Preqin1. In 2011 a new financial services regulatory structure took effect, which included the creation of the three new European Supervisory Authorities. This guide provides a brief overview of the European policymaking and new regulatory structure, and provides information on several issues of specific concern to hedges funds – and the institutions that invest in them. 1Source: Preqin, February 2013
  3. 3. About the European Union 3 The European Union (EU) is an economic and political union of 28 Member States. The EU was established in its current form in 1993 by the Maastricht Treaty. The Treaty of Lisbon, the latest amendment to the constitutional basis of the EU, came into force in 2009. The EU operates through a system of supranational independent institutions. These include the European Commission, the Council of the European Union, the European Council, the Court of Justice of the European Union, and the European Central Bank. The European Parliament is elected every five years. According to the EU, its policy making is focused on ensuring the free movement of people, goods, services, and capital.
  4. 4. Important Institutions of the EU 4 The European Commission is the executive body of the European Union. The body is responsible for proposing legislation, implementing decisions, upholding the Union’s treaties, and the general day-to-day running of the Union. The Council of the European Union (sometimes called the Council or the Council of Ministers) is the legislative institution that represents the executives of member states (the other legislative body being the European Parliament). The European Parliament is the directly elected parliamentary institution of the EU. Together with the Council of the European Union and the European Commission, it exercises the legislative function of the EU. The European Council is comprised the EU heads of state, the President of the European Commission, and the President of the European Council. The European Council has no formal legislative power. However, under the Treaty of Lisbon, it defines “the general political directions and priorities" of the Union. The European Central Bank is the EU institution that administers the monetary policy of the 17 EU Eurozone member states. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt, Germany. European Commission Council of the European Union European Parliament European Council European Central Bank
  5. 5. 5 In 2009, in response to the financial crisis, the European Commission proposed a new framework for financial supervision: The European System of Financial Supervisors (ESFS). The ESFS is an institutional architecture of the EU's framework of financial supervision. It is composed of three authorities: the European Banking Authority, the European Insurance and Occupational Pensions Authority, and the European Securities and Markets Authority. ESFS European System of Financial Supervisors EBA European Banking Authority EIOPA European Insurance and Occupational Pensions Authority ESMA European Securities and Markets Authorities European System of Financial Supervisors
  6. 6. 6 In January 2011, the new framework was implemented, with the EBA, EIOPA, and ESMA taking on the responsibilities of previously existing regulatory bodies. EBA European Banking Authority Committee of European Banking Supervisors EIOPA European Insurance and Occupational Pensions Authority Committee of European Insurance and Occupational Pensions Supervisors ESMA European Securities and Markets Authorities Committee of European Securities Regulators NEW OLD New Regulatory Framework
  7. 7. 7 To complement this framework, there is also a European Systemic Risk Board (ESRB). The ESRB is an independent body within the EU, responsible for the macro-prudential oversight of the financial system within the Union. Board Members of the ESRB include members of the European Central Bank, National Bank Governors, and Chairs of European Supervisory Authorities (ESAs). ESRB European Systemic Risk Board European Systemic Risk Board
  8. 8. 8 EBA European Banking Authority EIOPA European Insurance and Occupational Pensions Authority ESMA European Securities and Markets Authorities ESRB European Systemic Risk Board Headquartered in Paris, ESMA is responsible for safeguarding the stability of the European Union’s financial system by ensuring the integrity, transparency, efficiency, and orderly functioning of securities markets, as well as enhancing investor protection. It coordinates the work of securities regulators, and across financial sectors by working closely with the other authorities, in particular the EBA and EIOPA. ESMA is part of the European System of Financial Supervisors (ESFS). Headquartered in Frankfurt, EIOPA regulates certain activities of credit institutions, financial conglomerates, investment firms, insurance and reinsurance companies, and payment institutions. It is responsible for supporting the stability of the financial system, transparency of markets and financial products, as well as the protection of insurance policy holders and pension members and beneficiaries. EIOPA is part of the ESFS. Headquartered in London, the EBA regulates European banks. The EBA has the power to overrule national regulators, prevent regulatory arbitrage, and promote fair competition throughout the EU Common Reporting (COREP) is the standardized reporting framework covering: credit risk, market risk, operational risk, own fund and capital adequacy ratios. EBA is part of the ESFS. Headquartered in Frankfurt, the ESRB is responsible for the macro-prudential oversight of the financial system within the EU to help mitigate or prevent systemic risks to financial stability. It is charged with contributing to the smooth functioning of the EU’s internal market and ensuring a sustainable contribution of the financial sector to economic growth. The New EU Regulatory Framework
  9. 9. 9 ESMA is the coordinating body for EU Member State financial regulators. European Securities and Markets Authority (ESMA)
  10. 10. 10 Role and Responsibilities ESMA is responsible for coordinating actions of securities supervisors or adopting emergency measures when a crisis situation arises. ESMA is responsible for helping establish and implement a single set of financial rules across Europe. ESMA has two primary goals: • Ensure consistent treatment of investors across the EU, providing adequate investor protection through effective regulation and supervision. • Promote fair and equal competition among financial service providers and ensure effective and cost-efficient supervision of supervised companies. According to ESMA, the organization “contributes to the financial stability of the European Union, in the short, medium and long-term, through its contribution to the work of the European Systemic Risk Board, which identifies potential risks to the financial system and provides advice to diminish possible threats to the financial stability of the Union.” While ESMA is independent, there is full accountability to the European Parliament, Council of the EU and European Commission. Source: More About ESMA’s Role
  11. 11. 11 Financial regulation in the EU is governed by the Lamfalussy Framework which established the legislative approach to securities law. It was adopted by the EU in the final report of the Committee of Wise Men on the Regulation of European Securities Markets (an expert committee chaired by Baron Alexandre Lamfalussy). The Lamfalussy Framework proposed a four-level approach to European securities legislation: It first applied to the securities sector and was later extended to banking, insurance, and pensions. The framework has been brought into compliance with the Treaty of Lisbon, which entered into force in 2009, and the ESA and ESRB Regulations, which entered into force in 2010 and 2011, respectively. Baron Alexandre Lamfalussy EU Regulatory Process
  12. 12. Lamfalussy Framework at Work 12 Level 1: Framework Legislation Level 2: Implementing Measures Level 3: Supervisory Convergence Level 4: Enforcement
  13. 13. 13 There are a number of regulations currently under consideration in the EU that are of specific interest to hedge funds. These include: 1. Alternative Investment Fund Managers Directive (AIFMD) 2. European Market Infrastructure Regulation (EMIR) 3. Short Selling Regulation 4. Review of Markets in Financial Instruments Directive (MiFID II) 5. Market Abuse Directive (MAD) EU Regulations of Interest to Hedge Funds
  14. 14. 14 In April 2009, the European Commission proposed a Directive on Alternative Investment Fund Managers (AIFMs) with the objective of creating a comprehensive regulatory framework for European Alternative Investment Fund Managers. The proposed Directive was developed to help create common regulatory standards for all AIFMs that met specific criteria. The final agreement on the framework Directive (Level I) was achieved in November 2010 and the text entered into force in July 2011. The Commission asked the European Securities and Markets Authority (ESMA) to provide technical advice on the implementing measures of the AIFMD (Level 2). ESMA and the European Commission have continued to develop implementation measures throughout 2013. Member States were to have transposed the Directive and its implementing measures by July 2013, however, at the time of publication less than half of the 28 EU Member States have done so. ESMA continues to develop guidelines on the AIFMD in a number of areas. The final text of the AIFM Directive (July 2011) is here. More information on AIFMD here. Sources: Alternative Investment Fund Managers Directive (AIFMD)
  15. 15. 15 In September 2010, the European Commission published a proposal for a Regulation on OTC derivatives, central counterparties (CCPs), and trade repositories, now commonly referred to as the European Markets Infrastructure Regulation or “EMIR.” EMIR entered into force on August 16, 2012. ESMA and the European Commission continue to develop technical standards on implementation. EMIR is currently in its Level 2 implementation phase, with recent consultations coming from ESMA and other ESAs. Notably, EMIR calls for: • All OTC derivative contracts considered ‘eligible’, entered into between any financial and certain non-financial counterparties (subject to conditions), will be required to be cleared by a CCP; • All OTC derivative contracts not considered ‘eligible’ shall be subject to risk mitigation requirements, including the exchange of collateral or a proportionate holding of capital; • Counterparties to an OTC derivatives trade (cleared or not) shall report details of that trade to a trade repository; • CCPs shall be subject to registration and prudential and conduct of business regulation; and • Trade repositories shall be subject to conduct of business regulation. European Market Infrastructure Regulation (EMIR)
  16. 16. 16 In November 2011, European negotiators reached an agreement on an EU Regulation on Short Selling and certain aspects of credit default swaps. The regulation, which entered into force on November 1, 2012, was designed to establish a common regulatory framework and ensure greater coordination and consistency between Member States. Among other items, the new regulation: 1. Requires public disclosure of short positions over a certain threshold 2. Requires parties entering into a short sale to have borrowed the instruments, entered into an agreement to borrow them, or made other arrangements to ensure they can be borrowed in time to cover the deal. 3. Requires notification of significant positions in credit default swaps that relate to EU sovereign debt issuers. 4. Provides competent authorities with temporary power to require greater transparency or impose certain restrictions on short selling and credit default swap transactions. Both ESMA and the European Commission were to conduct a review of the Short Selling Regulation by the end of June 2013. ESMA released its findings on June 3, 2013; ultimately, it did not recommend significant changes to the regulation. As of publication, the European Commission has yet to release its review of the Short Selling Regulation. More information on EU short selling regulation can be found here. Source: Short Selling Regulation
  17. 17. 17 The Markets in Financial Instruments Directive (MiFID) came into force in November 2007. It replaced and expanded the Investment Services Directive. Its objective was to increase the integration and efficiency of EU financial markets. MiFID established a common regulatory framework for investment services in financial instruments across the EU and for the operation of regulated markets by market operators. The European Commission is currently reviewing the MiFID framework. In October 2011, the European Commission adopted proposals for (i) a revised Directive and (ii) a new Regulation (MiFIR). Both the European Parliament and Council of the EU have approved their respective reports on the MiFID proposal and are currently (September 2013) engaged in trialogue with the European Commission. Between them, these proposals: • Extend the existing regulatory framework both in terms of instruments and firms covered, so that, for example, certain commodity trading firms will fall within scope of the regime; • Impose regulatory requirements on firms undertaking algorithmic trading (including HFT); • Impose position limits on the trading of commodity derivatives; • Impose restrictions on third country firms providing services in the EU; • Introduce enhanced corporate governance requirements for investment firms; and • Introduce enhanced pre- and post-trade transparency provisions in respect of both equities and non-equities. More information about MiFID and MiFIR is available here. Source: Markets in Financial Instruments Directive (MiFID) II
  18. 18. 18 In May 2001, the European Commission proposed a directive to address insider dealing and market manipulation within the EU. The Market Abuse Directive (MAD) aimed to enhance the integrity of European markets by implementing common standards throughout all Member States. Currently (September 2013), negotiations among the European Parliament, Council of the EU, and the European Commission are close to finishing. More information on MAD available here. Source: Market Abuse Directive (MAD)
  19. 19. 19 European Resources: European Commission European Parliament headlines/ Council of the European Union ng=en European Securities and Market Authority (ESMA) European Banking Authority (EBA) European Insurance and Occupational Pensions Authority (EIOPA) European Systemic Risk Board European Central Bank For more information, please visit References