At present, AIFMD allows for either a gross or a commitment method of measuring leverage. AIMA has suggested a third method.
The European Commission has issued a “call for evidence” on the EU regulatory framework for financial services.
One of the comments the EC received on this subject came from the Alternative Investment Management Association, which suggested that it prioritize non-bank finance in its ongoing regulatory review.
Perhaps the most fascinating suggestion in the detailed and wide-ranging comment involves the way in which leverage ought to be measured under AIFMD, but that lede is thoroughly buried, and is discussed in detail only in “Annex III,” at the very back of the 43 page paper.
More Liquid Capital Markets
But let’s back up and look at the paper as a whole. AIMA’s premise here is straightforward: “economic growth increases with bigger and more liquid capital markets,” and the banking industry alone cannot fuel the growth the EC wants to Europe. Thus, the EC has to be concerned that “a number of barriers … prevent non-bank finance and capital from developing.” Constraints on the securitization process are among these.
AIMA makes six more specific points, in this order:
- Europe’s market for collateralized loan obligations stands in need of rejuvenation. One of the consequences of such a move would be greater stability for small and medium sized enterprises (SMEs), which would become less reliant on banks.
- Elements of the Basel III package may have a constraining impact on “dealers’ intermediation capacity,” an impact that requires care in how they are implemented.
- Regulatory reporting “consumes an undue amount of time and resources” among alternative investment managers and these demands could be streamlined without cost to the statutory mandates that gave rise to reporting requirements.
- The Alternative Investment Fund Managers Directive could use a tune-up. In particular, AIMA wants to see swift extension of the third-party passport, a reduction in the discretion of member states in regard to passporting, and “the introduction of a third measure of leverage as the existing two measures are not suited to sophisticated investment strategies.”
- The requirement for public disclosure of short sales has lessened the liquidity of equity markets and thus should be revisited.
- Finally, the rules governing over-the-counter derivatives are not consistent around the globe. AIMA notes one sign of progress here, though: the imminence of an equivalence determination under the European Market Infrastructure Regulation for the US regulatory framework.
The Third Measure of Leverage
All that said, let us now retrieve that buried lede, one we find in the fourth of those six points, and that isn’t really highlighted even there, the need for a third measure of leverage. At present, AIFMD allows for either a gross or a commitment method of measuring leverage.
The gross leverage is the gross notional position arising from derivatives transactions, added to the size of the balance sheet, where the sum is then divided by the net asset value.
The alternative “commitment” method accounts for netting and hedging arrangements in order to produce a better sense of the entity’s economic situation vis-à-vis leverage than the gross metric can. But AIMA notes important defects in the way this is done.
For example, the commitment method permits netting only when the underlying trade was “concluded with the sole aim of eliminating the risks linked to positions taken through the other derivatives instruments or security positions.” The sole aim? Such language makes the acknowledgement of a hedge dependent on the intention of a trader at the time of a trade, which is an oddly subjective focus.
Further, the markets have received no further guidance on how this intention, this soleness of aim, is to be ascertained, so the rule leaves au aura of uncertainty around permitted netting.
Another problem is that the existing rule allows for “duration netting” under certain circumstances, specifically where a manager is running a fund that in accord with its core investment policy primarily invests in interest rate derivatives, but isn’t very clear about how that is supposed to work. There are also subjective sounding expressions invoked in this connection.
Borrowing from Basel
AIMA suggests an adaptation of the Basel III measure of leverage to the managers working under AIMFD. This is its proposed third way, an estimate of the risk-weighted exposure of each underlying derivatives exposure added to the gross assets of the portfolio, then divided into the balance sheet total.
Behind the proposed adaptation is the idea that managers should “remain free to use any tools available to them to manage the risks within AIF portfolios effectively without having regard to leverage rations that favor one risk mitigation technique over another.”
That’s an important goal, and deserved a more assertive comment.