The Alternative Investment Fund Managers Directive and Hedge Funds’ Systemic Risk Regulation in the EU

Abstract

In the aftermath of the financial crisis, hedge fund regulation was put at the top of the European regulators’ agenda for their alleged contribution to financial instability. This paper studies the recently enacted Alternative Investment Fund Managers Directive (AIFMD) in the EU and its attempt to address potential systemic externalities of hedge funds. To include all relevant pan-European regulations addressing the sources of potential systemic risks of hedge funds, a systematic review of the recently enacted laws, regulations and implementing measures has been conducted. The analysis is predicated upon the methodology of law and economics with a consequentialist approach according to which the merits of the AIFMD and relevant regulations will be evaluated in terms of the achievement of the intended goals. The legislative process of the AIFMD suggests that hedge fund regulation in the EU was a politically motivated overreaction to their perceived contribution to financial instability. The aim of the AIFMD is mostly achieving the single market objectives, rather than addressing systemic risks. The EU regulators’ emphasis on investor protection can also be understood in light of the aim of creating a single European market for financial services. However, since the investors in hedge funds are professional investors, the AIFMD’s focus on investor protection in hedge fund regulation seems to be a misallocation of limited regulatory resources. Despite the fact that the impetus for the enactment of the AIFMD mostly involved the concerns about their systemic aspects and their contribution to the financial instability, hedge fund regulation in the EU only marginally addresses systemic risks that hedge funds can potentially pose to the financial system. In addition, the AIFMD's focus on capital requirements, leverage limits, and remuneration policies and practices, and requirements for AIFM's depositaries does not address the real concerns about hedge funds which are their interconnectedness with Large Complex Financial Institutions (LCFIs), and their potential herd behavior. Rather, imposing such limits is likely to undermine the benefits of hedge funds to European financial markets. Moreover, since the business model of a hedge fund can substantially differ from that of private equity, real estate funds, infrastructure funds or commodity funds, the one-size-fits-all regulatory approach adopted in the AIFMD will likely have adverse effects on hedge funds and undermine their benefits to the financial markets. Furthermore, hedge fund regulation is likely to put EU hedge funds in competitive disadvantage compared with their global competitors by overburdening EU hedge funds. Overall, it is primarily estimated that such direct and heavy-handed regulation of hedge funds imposing substantial costs to the industry can encourage regulatory arbitrage resulting in the ineffectiveness of the EU hedge fund regulation in the long run. This paper also sheds light on potential future regulations supplementing the AIFMD and possible future amendments thereto. It suggests that the EU’s regulatory policy towards hedge funds particularly in areas involving direct regulation of hedge funds arising from investor protection concerns should be revised. Instead, the regulatory focus should be shifted towards indirect regulation of hedge funds targeting their interconnectedness with LCFIs and their potential herd behavior. Otherwise, it is suggested that with the level of protection offered to investors of the AIFs, the AIFMD or the competent authorities of the Member States can loosen the statutory limits for investing in hedge funds.