The Changing Global Regulatory Environment
Following the 2008-2009 global financial crisis, regulators in the United States and Europe began to focus on risk in the financial markets. At the crux of the discussions was risk mitigation. The regulators focused on ways to prevent systemically important financial institutions from failing. The process was neither easy nor swift. As a result, there remains much uncertainty about how the rules will impact market participants. It is particularly uncertain for hedge funds, pension funds, endowments and other institutions that may or may not be designated as “systemically important.” Entities earning that designation may be required to register with regulators and may be subject to increased capital and margin requirements or receive various exemptions.
How Big is Too Big to Fail?
The Financial Stability Oversight Council (FSOC), which evolved out of the Dodd-Frank Wall Street Reform and Consumer Protection Act, is tasked with determining which financial institutions are “systemically important” (SIFIs). Although the threshold is $50 billion in assets, many much smaller entities could be affected, including:
- Insurance companies
- Hedge funds
- Private equity firms
- Other nonbank financial institutions
The effect of a SIFI designation on larger hedge funds, or even endowments or pension funds could:
- Restrict leverage
- Increase capital set-aside requirements
- Affect relationships with counterparties
- Change what types of assets can be used as capital (if money market funds are included, set-aside capital requirements could change)
- Raise margin requirements for pension funds, endowments or hedge funds not considered SIFIs.
In addition, standards approved last year in the EU will require large firms to hold capital valued at 7% of assets, adjusted for the amount of risk they pose. Higher capital levels in the United States could lead to an unfair playing field and be perceived as advantageous to some firms while detrimental to others.
Cross-Border Passporting of Funds
Financial reforms in the European Union include the Alternative Investment Fund Managers Directive (AIFMD) and the updated Undertakings for Collective Investment in Transferable Securities (UCITS), both of which are intended to facilitate cross-border marketing.
The AIFMD would authorize and regulate Alternative Investment Fund Managers (AIFMs) of non-UCITS funds, such as hedge funds, private equity funds, real estate funds, cash funds and others. Beginning 2013, it applies where AIFMs or alternative investment funds are domiciled or marketed in the EU and may require AIFMs of cash-collateral pools to be authorized and regulated by, or registered with, an EU regulator. As a result, these regulated funds may be required to create new products or incur additional costs to comply with the new rules, which differ from those in the United States.
The UCITS directive allows open-ended funds to operate across the EU based on authorization by a single state. UCITS is intended to offer a greater choice of investment products at lower cost through better integration of the internal market while providing investors with suitable protections through high-quality information and more efficient supervision.
MMFs Face Change in United States, Europe
Efforts Aim to Reduce Counterparty Risk
In the United States and Europe, proposed changes to regulations covering over-the-counter (OTC) derivatives swaps are largely in harmony. To help mitigate counterparty risks, regulators want swaps positions to be both reported and cleared through a registered clearing facility. However, there are important differences between the U.S. and European efforts.
- The requirement for clearing applies to all market participants in the United States; in the European Union, nonfinancial counterparties are exempt under certain thresholds
- The European Commission’s proposal doesn’t cover commercial forward or spot foreign exchange transactions and some kinds of physically settled commodity transactions
- The United States would require registration as well as new margin and capital rules for “major swap participants.” In the European Union, limited rules apply to nonfinancial counterparties subject to the clearing obligation
In the United States, proposed registration requirements raise questions about increased liability for pension funds, endowments and foundations, including whether they would need to hire compliance officers or be able to outsource that work. Higher costs for end users would appear likely, considering infrastructure changes, liquidity gaps and additional credit or capital required to offset exempted counterparties.