In what is becoming a fairly predictable trend, leading financial regulators are considering tightening regulations to limit global financial risk. However, recently proposed rules coming from the European Union may actually have a destabilizing impact on financial markets, despite the intention of the rules to decrease the risk that any specific institution may become too big to fail. Industry criticism has been swift, with a recent Reuters report suggesting that the changes may create a “regulatory own goal.”
New Rules would require a Depositor Institution to Monitor Hedge Funds
The proposed rule changes include requiring money managers that market funds in the European Union to appoint an independent depository institution. These banks will collect a fee from hedge funds in return for a guarantee of investor money in cases of unauthorized trading. The root driver of the additional regulation was the MF Global situation from 2011, where it is alleged that client funds were used to mitigate losing trades that the firm took on with its own money.
However, it is not clear where depository institutions would be willing to backstop such risk, nor is it clear what the cost would be to hedge funds for this kind of service. Guaranteeing all client investments from imprudent or fraudulent trading active would be a substantial risk for banks, perhaps even tying up large amounts of balance sheet resources to reserve against potential loses. The Alternative Investment Managers Association (AIMA) estimates that the cost to hedge funds may be as high as $6 billion per year.
Rule Change could Increase Market Risk if Hedge Funds move Offshore
Due to the high cost of the depository services suggested by the new regulation, many funds believe that this will make them uncompetitive with money managers located in less stringent jurisdictions. If regulations and compliance costs are not materially equal in all global jurisdictions, it’s reasonable to expect a flow of assets to the least costly places to do business.
Unfortunately for regulators, this often means these funds will be facing even less oversight than they have in their home jurisdictions. The reality of the large scale trades that hedge funds make means that money managers who are taking unacceptably high levels of risk in the under regulated jurisdictions actually puts the entire hedge fund market at risk. If a large trade fails to settle with a fund located in a questionable jurisdiction, another counterparty that may have been following rules in the European Union could also face severe economic consequences. The proposed stringent regulations could actually put European taxpayers in more jeopardy in comparison to less strict rules that would allow more funds to remain competitive in well monitored jurisdictions.
What Does This Mean For Job Seekers?
For the past several years, there has been a flow of some hedge fund jobs from highly regulated markets to markets where money managers have more freedom. Further politicization of hedge fund regulation may force even more regulators to impose unreasonable or irrational rules on the industry, forcing more jobs offshore. Those seeking jobs in the hedge fund industry need to be mindful of potential regulatory changes that may impact funds in their country. Many employees may be facing the choice between relocation or unemployment lines if such regulatory trends continue.