Limiting Leverage for Hedge Funds in Europe
Sarah Jane Leake | Bloomberg Law
Leverage under the Alternative Investment Fund Managers Directive1 is defined as “any method by which the exposure of an AIF is increased whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means.”
From 23 July 2013, alternative investment fund managers (AIFMs) will have to set maximum leverage limits for each alternative investment fund (AIF) they manage – including all non-EU AIFs they market within the EU.
Where it is considered necessary to maintain stability and integrity within Europe’s financial markets, national regulators will have the power to impose specific limits on the level of leverage that an AIFM may employ with respect to each AIF under its management.2
While the AIFM Directive is intended to support strong and stable markets, many stakeholders fear that this new power may unwittingly cause market instability and exacerbate the market turmoil it seeks to address.
Managing Systemic Risk
In line with the AIFM Directive, limits on leverage may only be imposed in order to “limit the extent to which the use of leverage contributes to the build up of systemic risk in the financial system or risks of disorderly markets.” The power to impose limits on leverage is subject to “Level 2″ implementing measures, currently being developed by the European Securities and Markets Authority (ESMA) after extensive consultation with industry over the summer.3 These measures should take into consideration the different strategies employed, the varying market conditions in which funds operate, and any likely pro-cyclical effects arising out of the exercise to impose limits.
In response to ESMA’s consultation, a number of stakeholders, including the UK Hedge Fund Standards Board (HFSB),4 argued that imposing limits on leverage is not an appropriate or adequate tool for managing systemic risk in Europe’s financial markets. In the HFSB’s opinion, there is no evidence at present to suggest that AIFs are systemic by nature – they do not, for example, share the same characteristics as banks (e.g., deposit-taking, significant maturity transformation, etc.).
It should be noted that higher-cross industry leverage does not pose higher systemic risk. Leverage is a direct function of market volatility; high leverage across investment strategies is typically indicative of low market volatility. If the volatility of a particular market increases, the margin requirement for exchange-traded products is similarly increased. As such, high leverage in the sector is only likely to pose high systemic risk where used without proper collateralisation.
Furthermore, leverage can sometimes arise as a by-product of building sophisticated portfolios to match the specifics of a desired investment strategy. For example, transactions intended to reduce the overall riskiness of a portfolio might lead to an increase in certain leverage measures.
The Importance of Leverage
Leverage is one of a number of tools that allow investors to calibrate the risk/return profiles of their investments in line with their specific risk appetite and return objectives. Large investors, such as pension funds, typically achieve this by allocating a large variety of asset classes, strategies, etc. and by combining these with a mixture of high risk/absolute return and low risk/return strategies. As such, leverage, and thus risk-taking, is integral to the functioning of today’s markets.
Investors with a substantial risk appetite are needed more during a crisis than at any other time. With this in mind, it would be counterproductive to restrict risk-taking during times of volatility for those who are both willing and able to take and manage such risks.
A Step too Far?
To give regulators the power to limit leverage suggests that they are best suited to determine the appropriate level of leverage. For many, the AIFM Directive goes far beyond the regulation of individual funds and seeks to control risk across the sector. They fear that regulators across the EU would have a carte blanche to step in and impose restriction after restriction, which would, ultimately, cause the sector to die a slow and untimely death.
On a practical note, it might be more appropriate to require AIFMs to ensure that the leverage employed for each AIF they manage is clearly assessed and disclosed to investors, and to let investors decide how much leverage is too much leverage. Today, particularly in the wake of the crisis, the sector considers itself sufficiently well-positioned to take and manage risks. Given the stochastic nature of financial markets, sector-autonomy remains important, not least to help ensure that the AIFM Directive does not end up legislating against risk-taking in this area.
In emergency situations, it is undoubtedly necessary for regulators to take immediate action without the benefit of public consultation. At the same time, though, markets depend on investor confidence which, in turn, depends on some degree of certainty. Confidence and certainty cannot be achieved if regulators are allowed to act precipitously and without consultation, as this makes it hard for investors to manage their investment activities.
Stakeholders stress that any decision to impose limits on leverage should only be taken after lengthy consultation, considered analysis of empirical data, a thorough impact assessment and cost/benefit analysis and consistent co-ordination between regulators. Regulators should bear in mind the overall impact on investor confidence, particularly where regulatory intervention is likely to affect price formation, causes unintended market volatility, or disincentivises investors at a time when they are most needed. It must be remembered that intervention can easily send off the wrong signals – it could wrongly be taken to indicate that particular risks have built up in systemically important institutions and this, in turn, could impact on their ability to raise capital.
To maintain investor confidence, and preserve market stability, affected AIFMs must be given sufficient notice of the action in order that the effect of the action can be properly considered without giving rise to instability.
In light of feedback to its consultation over the summer, and issues arising out of the open hearing held in Paris in September, ESMA is now in the process of finalising its advice to the Commission, which it will submit before the deadline of 16 November.
Many fear that regulators’ power to limit leverage, if used too frequently and without appropriate forethought for its potential unintended consequences, could force hedge funds out of the EU offshore in search of leverage. Yet, many are grateful that no explicit leverage has been set in stone – as will soon be the case in the U.S. where, pursuant to section 165(j) of the Dodd-Frank and Wall Street Reform and Consumer Protection Act, certain hedge funds with more than $50 billion assets under management will be subject to strict leverage requirements (15 to 1) – the exact details of which are to be finalised by the Federal Reserve in the near future.
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