FSA Will Tailor EU Remuneration Directive For Hedge Funds

by Robin Pilgrim, LawAndTax-News.com, London

29 September 2010

Dan Waters, Director, Conduct Risk, and Asset Management Sector Leader of the United Kingdom’s Financial Services Authority (FSA), has used a speech to the Alternative Investment Management Association’s 2010 Annual Conference to explain how the emerging European Union (EU) regulatory regime for remuneration should be tailored to the asset management industry.

At the end of July this year, the FSA announced plans to update its Remuneration Code to take on board remuneration rules required by the EU’s Capital Requirements Directive (CRD 3) and the Financial Services Act 2010 (FS Act). The FSA’s current Code applies to the largest banks, building societies and broker dealers. However, CRD3 will bring over 2,500 firms within the scope of the Code. These will include asset managers, hedge fund managers and collective investment firms.

The existing Code requires that firms apply "remuneration policies, practices and procedures that are consistent with and promote effective risk management". Although the Code is broadly consistent with CRD3 provisions and the FS Act, the FSA will be required to make some changes to ensure full alignment. Up to October 8, it is consulting on the changes that will necessary to the Code, and CRD3 will need to be implemented by January 1 next year.

While the core driver of regulating remuneration in the banking sector was the desire to curb excessive risk taking behaviour that could threaten the viability of a trading bank and potentially expose the public to underwriting such a failure, Waters said that, under CRD3, regulators are permitted “to flex the more detailed requirements of the Directive so as to achieve its overarching purposes across a range of different types of institutions.”

He pointed out that asset management and banking business models are fundamentally different in that “asset management is an agency business and the capital of the firm is not put in play in managing assets on behalf of clients as it would be in proprietary trading activities.” Asset managers are only required “to hold at least the capital they would require to wind down their business in an orderly manner.”

Nevertheless, in the FSA’s opinion, there is the potential for systemic disruption arising, not from the failure of a fund manager itself, but from the potential impact of a fund or group of funds that could have a systemic presence in the market. “Hedge funds,” he explained, “are the most obvious example.”

He added that the FSA, however, has “taken steps in the UK to address these concerns, by gathering extensive information from both hedge fund managers and their prime brokers, in order to assess the risks of potential systemic presence and to mitigate them. We consider that generally this use of regulatory tools is more likely to be relevant in terms of addressing systemic issues in funds than any across the board intervention on remuneration.”

In addition, the FSA does not believe that the remuneration of asset managers is essential in order to establish a level playing-field with investment banks and avoid a movement of proprietary traders, and therefore of "excessive" risk, into hedge funds. The far greater risk seen by the FSA is that “misguided European regulation of hedge funds drives them out of Europe, depriving European regulators of both the information we now have about their activities in European markets and the regulatory power to curb abuses, while these funds continue to invest in European markets.”

It is from a consumer protection viewpoint that the FSA does consider it appropriate for regulators to worry about potential conflicts of interest in the remuneration structures of fund managers. Potential distortions arise, for example, from performance fees, excessive co-investment or over reliance on ad valorem fees that could incentivize risky tactical trading in order influence the calculation of remuneration at particular points in the investment reporting cycle, or otherwise incentivize managers to take risks beyond the fund’s investment mandate.

Nevertheless, Waters said “the considerable variance in the way which conflicts of interest can occur and breadth of the controls that can be used to manage and mitigate them, calls into question the extent to which the specific or arbitrary application of the more detailed requirements in CRD3 will serve to deliver appropriate regulatory outcomes in all cases across the diverse population of firms to which the CRD remuneration rules apply.”

He pointed out that “CRD3 proposes a hard requirement to defer at least 40% of variable remuneration over at least a three year period. We are concerned that in the case of asset managers, such a hard-edged requirement does not reflect the specificities of different types of funds, for instance those where the investment period of the fund is greater than or less than three years.”

“It is for this reason,” he concluded, “that we do not propose a rigid approach to those elements of the CRD3 remuneration principles that are relevant in the design of remuneration structures for asset managers. Instead we have proposed that some elements of the remuneration code are applied proportionately and in some cases on a comply or explain basis. Such elements include the nature of remuneration payment, deferral of performance related remuneration, such as bonuses, and performance adjustment of those awards.”

Recommended