Is E.U. Crackdown on Hedge Funds Bad for Business?

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Lefteris Pitarakis / AP

People walk in London's Canary Wharf financial district

Hedge funds have a lot to answer for. They control more than $2 trillion in assets worldwide, use complex and secretive trading strategies to deliver high investment returns, are subject to little or no regulation, and — according to their critics — they fueled the risk-taking culture that led to both the credit crunch and the recent run on Greece's debt. They are the reason the world is now so familiar with the practice of short selling: selling borrowed assets on the expectation that they can be bought back at a lower price. Governments have become so suspicious of how hedge funds work that on Tuesday night Germany unilaterally banned naked short selling, where the trader sells shares without establishing that they can be borrowed in the future, despite the fact that the practice is rarely used in Germany — news that sent the euro to a four-year low against the dollar.

That followed a move earlier Tuesday, in which E.U. finance ministers backed plans to rein in hedge funds with tough new licensing rules, riding over objections from the new U.K. government and the City of London, where 80% of European funds are based. The draft law aims to put "alternative investment funds" — hedge funds and private equity — under closer scrutiny by a new pan-European watchdog, which will be armed with the power to cap their borrowing from 2012. It will oblige fund managers to register with national authorities and reveal to both regulators and investors closely guarded information about their investments and borrowings.

The law also contains plans to make it much more difficult for non-E.U. hedge funds to sell their products across the single market, by forcing them to register in each individual member state. This proposed measure has already raised the hackles of the Obama Administration, with U.S. Treasury Secretary Timothy Geithner warning it could shut U.S. funds out of the E.U. However, E.U. officials insist the move is in line with pledges made by G-20 leaders at their London summit in April last year to set up the oversight, registration and reporting of hedge funds.

Indeed, the hedge fund law is part of a bigger financial-services overhaul that E.U. Internal Markets Commissioner Michel Barnier is planning. Other reforms in the pipeline include a crackdown on the derivatives market, new legislation on credit rating agencies, limits on banker pay, and new watchdogs being set up to police banks, insurers and markets. Speaking on May 11 in Washington, D.C., before meeting Geithner and other key Administration officials, Barnier talked of the "enormous collective, political responsibility" to ensure the mistakes that led to the global financial crisis would not be repeated. "We have responded to the call from the G-20 to take action to build a stronger, more globally consistent regulatory and supervisory system for financial services," he said. "We must ensure that our financial systems act in the interest of the real economy, not the other way round."

The push to set new rules reflects widespread anger across the E.U. at the lax oversight that many feel is at least partly to blame for the credit extravagances that led to the financial crisis. "This crisis has shown that the interactions between unregulated or lightly regulated market players can create systemic risk," says Rym Ayadi, Senior Research Fellow at the Brussels-based Center for European Policy Studies (CEPS). "The game has totally changed. We cannot have big players threatening market stability."

Not surprisingly, the E.U.'s attempt to regulate has run into fierce opposition from the hedge fund sector, whose European operations are concentrated in London. The British Private Equity and Venture Capital Association has dubbed the draft law as "one of the least thought-through pieces of proposed legislation for some time," and warned that the "excessive administrative burden" would drive lucrative business out of the E.U. to places like Dubai, Zurich and New York City. Europe's largest hedge fund manager, London-based Brevan Howard, has already relocated 50 staff to Geneva, citing fears that the planned law will curtail its ability to deal with non-E.U. investors. Other investors say the proposals could cut off a major source of financial innovation that Europe sorely needs to jump-start its economy.

The measures might also miss their target. Hedge funds are widely blamed for both the financial crisis of 2008 and for supposedly dumping and short-selling Greece's euro government bonds, but Ciaran O'Hagan, an analyst at Société Générale in Paris, says this is scapegoating. "Hedge funds have not been big drivers of sovereign bond markets. Indeed they have been marginal players on the whole," he says, pointing out that it's banks rather than hedge funds that bear much more of the blame for the credit crunch.

But those arguments cut little ice with E.U. ministers: the U.K. was the only country to oppose the decision, which will be remembered as an early defeat for the country's new Conservative-Liberal Democrat government which took office only last week.

Fredrik Erixon, director of the Brussels-based European Centre for International Political Economy says the vote reflects a regulatory backlash against financial services, which can only damage the E.U. "Hedge funds have very little to do with the crisis, but governments are looking for someone to blame," Erixon says. "The problem is that many countries do not have a hedge fund sector, yet they have a say in regulation."

There may still be a chance to calm critics in London and Washington before the proposals become law. A separate version of the bill, backed by lawmakers in a key European Parliament committee on Monday, would give fund managers the freedom to operate throughout the single market on the condition that they voluntarily adhere to E.U. standards. Internal Markets Commissioner Barnier aims to broker a compromise between MEPs and finance ministers before July, and he has signaled his preference for the Parliament version of the law. But even if hedge funds dodge this bullet, the continuing fury against bankers and investors suggests that it won't be long before someone takes another shot at taming the financial services sector.