Regulating Hedge Funds

The European Parliament passed yesterday a directive to regulate hedge funds, officially known as the Alternative Investment Fund Management (AIFM) Directive. The directive requires hedge funds and private equity funds to register with statutory regulators and provide basic information about their activities for the first time.

The AIFM Directive is Europe's interpretation of global principles of hedge fund regulation set out on 22 June 2009 by IOSCO, the International Organisation of Securities Exchange Commissions. Those principles require registration, reporting and require banks lending money to hedge funds (known in the business as hedge fund counterparties) to review the riskiness of providing the leverage that they do.

Hedge funds attracted investors before the financial crisis and criticism during the financial crisis because they make money by speculating on market trends, and then 'leveraging' the cash on hand they have from investors with loans picked up at low cost from Japan (this practice of shopping around for loans across currencies is known as a carry trade) and engaging in short selling. Although hedge funds were not responsible for the banking practices that led to the financial crisis, they actively bet against the financial institutions and instruments that did, hastening the speed and intensity of banking collapses in 2008, and making enormous profits doing so. At certain points during the crisis, trading extended into naked shorting, which was then criminalised in some jurisdictions.

The AIFM Directive had a bumpy ride through legislation. It passed the Council the first time only by virtue of the UK changing from a Labour to a Conservative government, which then fought hard to ensure that American hedge funds, many of which have offices in London, would have equal access to the financial markets of all EU member states based on the regulations prevailing in their EU bridgehead. The UK therefore agreed to accept hedge fund registry if it could effectively retain the light-handed approach to financial market regulation for which it is known.

The deal has been struck.