The movements of Europe’s Alternative Investment Fund Management Directive toward implementation and thus toward the force of law remind me of the old fable concerning a boastful oak tree. The oak lorded it over the skinny reed, proud of its might and inflexibility. But during the inevitable storm, it was the oak that cracked and fell.
Regulatory systems are all too often oaks, not reeds.
On March 26, 2012, the European Union released a draft of its Level 2 implementing rules. These rules, as the Alternative Investment Management Association has observed in some detail, differ in significant respects from the technical advice on this subject the EU has recently received from the European Securities and Markets Authority. The differences are not random. They follow a consistent pattern: on point after point, ESMA had attempted to allow for the industry’s heterogeneity and for the inevitability of the unforeseen. On point after point, the EU has thrown aside such qualifications and, one might even say, thrown aside caution in the process.
In the form in which the AIFMD received Level 1 approval last year, it was but an outline. Yet what was clear was that managers would in the end have to disclose a good deal more to their home market authorities than has been their wont; that leverage shall be closely monitored once it is deemed to have been employed “on a substantial basis at the level of the AIF,” and leverage may well be limited outright; further, it is clear that depositary institutions will be saddled with new liabilities. These bullet points might be implemented with various degrees of rigidity, and that is the continuing subject of debate.
Leverage and Offsets
Some of the ESMA/EU differences involve the issue of leverage mentioned above. ESMA recommended that it would be inappropriate “to seek to specify a quantitative threshold at which leverage would be considered to be employed on a substantial basis,” given the “heterogeneous population of AIF” covered by the directive. The EU’s draft regulation has ignored this warning and has created a homogenous threshold. Leverage will be “considered to be employed on a substantial basis … when the exposure of an AIF … exceeds two times its net asset value.”
This raises another question: how is that degree of exposure for that purpose to be calculated? ESMA had proposed a method of calculation that takes into account offsetting arrangements, that is, “combinations of trades on financial derivative instruments and/or security positions” aimed at limiting the risks of other trades and positions. The offsets would enter into calculation of exposure, and thus into the definition of the extent of leverage, if they satisfy two conditions: the arrangements are “likely to remain materially effective in times of stressed market conditions” and there is a “verifiable reduction of risk at the level of the AIF” as a consequence.
The EU’s draft regulation omitted this whole discussion, substituting a brief reference to the “commitment method under Article 10.” This is the UCITS method of total risk exposure, in other words, a calculation without offsets. AIMA’s analysis says this “could create serious problems for the industry, its investors and competent authorities” by creating a misleading picture of the realities of the industry.
Other changes involve depositary institutions. Those who drafted the Level 2 rules seem to be interested, for example, in fine-tuning the contracts by which such institutions are appointed, requiring that the contract stipulate “the geographical regions in which the AIF plans to invest” with “country lists and procedures to add and/or withdraw countries from that list.”
The drafters also introduced new liabilities with regard to the depositary institution’s monitoring of the AIF’s cash flows. Where ESMA’s draft had said the institution must ensure that the cash flows are “properly monitored,” the Level 2 language ups the ante, saying the institution shall “ensure an effective and proper monitoring” which will identify significant cash flows “immediately.”
Furthermore, ESMA’s advised was that depositaries be required to monitor external events beyond their control that may result in “a loss of a financial instrument” to the extent they can “reasonably identify” such risks. The Level 2 draft has removed the qualification of reasonableness.
AIMA cautions that if the Level 2 rules are adopted as written, they could be disruptive “to the asset management industry in the EU and globally, potentially undermining some of the stated policy goals of investor protection and financial stability.”
The new language regarding depositary institutions, in particular, could impose stress on the banks that perform that function, “exacerbating the ‘too-big-to-fail’ problem.”