Directive on Alternative Investment Fund Managers - European Union Committee Contents

Memorandum by Citadel Investment Group


 (a)   What economic benefits arise from Alternative Investment Funds?

Benefits to the UK economy

  Lord Myners has already outlined the benefits to the UK economy deriving from Alternative Investment Fund Managers ("AIFM"). Based on International Financial Services London research, 20% of global hedge fund Assets under management ("AUM") in 2008 were in Europe. Of this 20% London accounted for circa 18% of global AUM (thus close to 90% of European AUM). As a share of the number of managers, London had two-thirds of European managers at the end of 2008. The economic benefits of tax revenues and direct and indirect employment speak for themselves. For this reason, our submission focuses on the economic benefits to markets and investors.

Investment choice

  AIFM provide sophisticated investors with investment choice. AIFM are able to respond quickly to investor demand for specific products. Demand for such products and investment return will increase in Europe given the ageing demographic and consequent pressure on pension funds to achieve high returns. A number of Dutch pension funds, for example, have raised these concerns stating that "the current Directive may reduce investment opportunities and risk diversification, lead to higher costs and lower returns".

Capital provision and risk transfer

  AIFM play a significant role as capital providers and in facilitating risk transfer in modern economies. They are a major source of risk capital in certain sectors (like convertible bonds and mezzanine debt) that are not well served by either depository institutions or traditional asset managers. In addition, they are an alternative source of liquidity and contribute to well functioning capital markets. Both of these activities lower the cost of capital to companies and consumers.


  AIFM have traditionally been a major provider of liquidity in equity markets. AIFM are willing to take offsetting positions and provide liquidity to market participants. By developing superior hedging technology to manage their risks, AIFM require a smaller price concession to provide liquidity. This has lowered transaction costs for regular market participants and investors.

Exchange platforms

  AIFM have been key players in the post-MiFID landscape both as major liquidity providers on traditional exchange platforms along with the new generation of Multilateral Trading Facilities ("MTF") that offer platforms that seek to increase competition in equities execution. AIFM have also been able to act as providers of capital to a number of these new platforms. An example of this is Citadel Securities' recent investment in the Equiduct platform that operates a pan European electronic trading platform for the Borse Berlin AG, a Recognised Investment Exchange. The Equiduct platform seeks to provide an all-in-one solution for trading equities in an increasingly fragmented European market. It also assists market participants in satisfying their best-execution obligations to their clients, by providing price transparency and price improvement across a number of European markets.

Technology provision

  As other markets like foreign exchange and the trading of government debt have migrated partially to electronic markets, AIFM have extended the technology to these markets, benefiting a broader group of investors.

Price discovery

  Similarly, AIFM devote significant resources to undertake research about companies and the broader economy. By making investment decisions based on the findings of their research, AIFM help ensure that prices reflect the true economic prospects of a company. For example, CDS provide a far better gauge of a reference entity's creditworthiness than ratings that do not reflect this depth of analysis and are paid for by issuers.

Market efficiency

  Investment organisations are becoming increasingly specialised in providing either market exposure (Beta) or superior investment performance (Alpha). This separation of "Alpha" from "Beta" is demanded by investors so that they can monitor risk and performance in a transparent manner. There are natural limits to the scale at which "Alpha"—capture organisations can operate. If they are large relative to a sector, they cannot execute their ideas efficiently. In contrast, most traditional financial institutions (banks, insurance companies and "Beta" replicating investment firms) benefit from increasing returns to scale. In fact, the financial crisis has resulted in increased concentration in investment banking and money management. This has reduced competition in these markets and in the long run leaves us more vulnerable to systemic risk. While prudent regulation can help mitigate the systemic risk, AIFM can play an important role by providing competition to the financial supermarkets thereby increasing market efficiency without posing macro economic risks. In short, AIFM reduce risk concentration and drive down transaction costs.

 (b)   What risks to financial markets arise from Alternative Investment Funds?

We firmly believe that no AIFs in today's market place are large enough to pose systemic risk by themselves.[1]

Herding behaviour

  It is possible that, if the activities and positions of certain AIFM are known in the marketplace, herding behavior can result in many participants having identical or similar positions. Such herding behavior can magnify price volatility both as prices move up and even more dramatically in declining markets due to forced de-leveraging. There are two complementary ways to address this problem:

First, transparency

If all AIFM are required to report certain position data to a regulator, the regulator can aggregate data across institutions to assess the concentration of risk. The UK Financial Services Authority has been piloting a questionnaire that seeks to gather such data. The challenge is to ensure that the information is meaningful, "like for like" and treated with an appropriate level of confidentiality at a firm level.

Secondly, by requiring a centralised clearing house

For standardised contracts (versus bilateral clearing) regulators can reduce the risk of forced de-leveraging caused by uncertainty about the credit worthiness of counterparties. Furthermore, encouraging the migration of trading to electronic exchanges with centralised clearing can preserve anonymity of trading thus minimising the herding behavior that is at the root of this source of systemic risk. Centralised clearing of products will also help address the transparency issues. Additionally, as contracts are standardised and move to a centralised clearing house (increasing price transparency and making it easier to transact in such instruments), liquidity increases and the Bid Offer spread decreases. This reduces costs for all investors including corporations, pension funds, insurance companies and AIFM.

Need for risk-management processes

  AIFM can create "micro" risks for their investors by not having a systematic investment process or ignoring prudent risk management principles. Most institutional investors expend significant resources in ensuring that the managers they select have rigorous investment processes in place. However, not all institutions have the scale and expertise to conduct a thorough due diligence of the mechanisms and technology that an AIFM has in place to manage liquidity, market, counterparty and operational risks. The proposed Directive can be helpful in conjunction with national regulators in ensuring that risk management is taken seriously (the Directive requires separate reporting lines for risk management and investment teams) and meets a certain threshold of accountability. Similarly, guidelines in disclosure and reporting can ensure a level of transparency between the AIFM and the investor.

 (c)   Will the Directive help reduce these risks?

The Directive, as drafted, does little to address the risks of herding outlined above. Moreover, by adversely impacting AIFM, there is a risk that the Directive could reduce the benefits which AIFM provide, namely investor choice, reduced concentration risk, and provision of capital and liquidity. These benefits are more important than ever at a time of recession. AIFM are part of the solution. They will provide capital to economies that need to recover.


 (a)   To what extent is there a need to create a single regulatory regime for Alternative Investment Fund Managers in the European Union?

  It is generally agreed that AIFM were not responsible for the financial crisis. This was highlighted in a number of the reports that have been carried out following the crisis including the Turner Report and de La Rosiere report. As such we believe it is critical that any regulatory response directed specifically towards AIFM is proportionate to the risks posed by AIFM.

Nonetheless, we agree that AIFM based in the EU should be the subject of appropriate and proportionate registration and authorisation requirements. Many AIFM based in the UK have been the subject of regulation by the FSA for a significant period of time. Whilst enhancements, particularly surrounding transparency, may be required, we would underscore the effectiveness of this regulation. The creation of a level playing field with respect to AIFM regulation across Europe is a desirable outcome for a free and open European market.

We believe that the proposed EU Directive on Alternative Investment Fund Managers (the "Directive") should focus on issues of financial stability and systemic risk, based on proposals for transparency and disclosure. We do not think it appropriate for the Directive to seek also to introduce a single EU passport for the marketing of AIFM, although we accept the advantages of such a passport in the longer term. For now, we believe that Member States should be able to maintain their private placement rules, either in parallel with the Directive, or pending full consultation surrounding the appropriate form of regulation to support an EU-wide passport for the marketing of AIF.

 (b)   Does the Directive achieve its objectives?

  We welcome the general objective of the Directive, which is to achieve a complete and consistent framework for the supervision and prudential oversight of AIFM. However, we are concerned that the Directive as drafted will not achieve its stated objectives, or will do so in inappropriate or disproportionate ways. We have a number of specific concerns.

Legislative simplicity

  Financial services within the EU are already governed by a number of EU Directives stemming from the Financial Services Action Plan, for example MIFID. It is important that a new AIFM Directive does not cut across existing legislation.


  Investment funds are managed by a wide range of different institutions. It is important that the Directive treats all types of institution equally. We are concerned that some of the provisions put AIFM at a disadvantage vis a vis other regulated financial institutions in the EU. For example the imposition of particular disclosure and short-selling provisions in the Directive are applicable only to AIFM.

Any European requirements must, however, be seen in the broader global context. We are concerned that the Directive is being adopted in the EU under an aggressive timetable that does not take into account global regulatory initiatives, for example, those proposed by the G20.

Impact assessment

  An impact assessment was prepared by the Commission in respect of the Directive, but it is widely acknowledged that it falls well short of the EU "Better regulation" principles and what could reasonably be expected given the likely effect of the Directive. The Commission's own Impact Assessment Board raised concerns about the first draft of the impact assessment and expressed reservations even about the latest version. In particular, the assessment does not attempt to estimate the economic impact of the measures contained in the Directive, either on financial markets or on the economy more broadly. We therefore support calls for a revised impact assessment which seeks objectively to measure these effects.


  The provisions in the Directive relating to depositaries are unworkable in at least three important ways.

    — First, the Directive places strict liability on the depositaries of AIF assets. This will either deter many existing providers from offering depositary services, or vastly increase the cost of doing so.

    — Second, as drafted, the Directive only permits EU Credit Institutions to act a depositaries for AIF. As a result, large numbers of international prime brokers would be potentially excluded from the AIF space in Europe thereby significantly reducing competition and increasing risk concentration in the institutions still able to provide these services.

    — Third, the requirement to use EU credit institutions as depositaries will effectively limit the ability of AIFs to invest in emerging markets assets, since such assets need to be held with local depositaries outside of the EU.

  The impact of these provisions on depositaries will ultimately be borne by end investors, who will experience both a knock-on increase in the costs of investing and reduced investment choice. We applaud the objective of increasing investor protection, but we believe that many of the concerns surrounding depositaries stem from national insolvency laws. As a result, they are better dealt with at a national level, rather than in this Directive.

Independent valuator

  The requirement for an "independent" valuator runs the risk of adopting legal formality over substance. AIFM are varied in their size, structures and operations. As such, they are not conducive to a single one size fits all approach with respect to independence. IOSCO's Principles for the Valuation of Hedge Funds, in contrast to the Directive, identifies nine principles that should apply to hedge fund portfolio valuation. These principles focus on the importance of consistent valuation procedures that are applied consistently and in a transparent fashion. At the same time, it recognises that hedge funds are varied in their size, structures and operations and as such stops short of mandating a particular approach with respect to independence. We support IOSCO's approach which is in line with the approach taken by AIMA and the HFSB.

Cross-border marketing and third-country funds

  Of particular concern to us is the cross-border impact the Directive would have on AIFM. Citadel is a significant global alternative investment manager which was founded in the United States and is structured on an international basis. The model we adopt is similar to that adopted by many international managers who generally operate funds based outside the EU. Such international managers, many of whom have a significant presence in the EU, will be affected by a number of the provisions of the Directive, particularly those relating to marketing third country funds and the delegation of certain functions outside of the EU (for example valuation, administration and depositaries).

Whilst the creation of a single market for the marketing of AIF to institutional investors in the EU is a commendable objective, we are concerned that the provisions as drafted could operate to preclude third-country funds from EU investors. This would disadvantage international groups that are less likely to be able to re-structure to bring their funds on-shore. Also, and more importantly, it would limit access by EU investors to a significant number of sophisticated international AIFM. According to the ECB August 2005 report, some 91% of AIF were domiciled outside of the EU, accounting for 89% Global AUM.[2]

  The provisions bite particularly hard on international firms that choose not to have a presence in the EU. EU investors will simply be denied access to these AIF, notwithstanding the sophistication of the individual investors. This amounts to a closure of the EU capital markets to large number of investment opportunities that are currently open to them under existing national private placement rules. We do not believe the equivalency provisions that are currently contemplated by the Directive will operate to address this issue. Whilst these are a good idea in principle, historical efforts on mutual recognition are clear evidence that this approach is exceedingly difficult to implement in practice.

  In addition, we are concerned about the ability of EU-authorised AIFM to market offshore funds after the transition provisions have fallen away. The marketing of such funds is subject to the existence of a tax-sharing agreement between the AIF domicile jurisdiction and the member state in which the fund in question is to be marketed. It is completely inappropriate to tie the marketing of funds to the implementation of a tax initiative in this Directive which relates to financial services. Any Directive in taxation should be dealt with as such. It is also hard to see how this particular provision falls within any of the objectives of this particular Directive.

  Finally, we do not believe that institutional investors are seeking the type of regulation and protection that aspects of the Directive are mandating.


  The objective of proper monitoring of macro-prudential risks is key to enhancing regulatory oversight of the financial markets as a whole. We therefore welcome enhanced transparency, subject only to the caveat that the information collated is meaningful and treated with an appropriate level of confidentiality at a firm level.

Leverage limits

  The provisions of the Directive that provide for the setting of hard leverage limits, combined with the ability of regulators to intervene at times of market turmoil to reduce leverage, could, in our view, work against the Directive's stated objectives and increase macro-economic risks. Firstly, it is unclear how leverage should be defined. Secondly, a firm that has locked in robust lines of liquidity, negotiated on a commercial basis, could be forced to de-leverage when its liquidity profile is not compelling it to do so. Regulatory intervention to force such deleveraging, which would presumably occur only at times of market stress, could backfire. This is because the threat of forced deleveraging could increase uncertainty, enhance the risks of fire sales and encourage irrational behaviour.

 (c)   Should the objectives of the Directive be modified?

We do not believe that the key objectives of the Directive require modification. As outlined above, we are very concerned about the mode of implementation that certain aspects of the draft Directive has adopted.


 (a)   How does the Directive compare to existing or proposed regulation of Alternative Investment Funds outside of the European Union, particularly that of the United States

  Historically, the US has required the registration of publicly offered pooled investment funds (referred to in the US as investment companies) but has exempted most private funds, including hedge funds and their managers, if certain conditions are met. The US is now proposing to register virtually all fund managers, but not the underlying funds. The leading US proposals, discussed further below, do not impose detailed regulatory rules on private funds comparable to the regulations applicable to investment companies.

Below is a simple table highlighting some key differences between the US and EU approaches. We attach an Annexe giving more detail. We would be happy to give oral evidence on this issue.
IssueUS EU
Registration for fund manager/adviser YesYes
Registration for fundNo ?
Leverage limitsNo*Yes
Liquidity management rulesNo* Yes
Minimum capitalNo*Yes
Independent valuationNo** Yes
Independent custodianNo** Yes
Cross-border marketing restrictionsNo*** Yes
*   Current proposals would impose such requirements on advisers and funds that are systemically significant.
**   There are no explicit requirements for independence but proposed rules would impose certain verification obligations.
***  As long as funds are marketed privately and only to investors meeting certain eligibility criteria.



Current Regulation

    — The US has typically approached regulation of pooled investment funds through requiring registration either of the fund itself or of the fund manager unless an exemption or exception is available. — Most private funds have been excepted from registration because they have not made a public offering and either are owned by a limited number of investors and or are owned solely by sophisticated investors. Private fund managers have not been required to register in the US if they do not offer their services publicly and have fewer than 15 clients (each fund is considered one client and the fund's underlying investors are not counted for these purposes). — Unregistered private funds and managers are subject to prohibitions against fraud and manipulation and all of the market conduct rules that apply to investors generally.

    Current Practice

    — While managers are not explicitly required to do so, and funds are not explicitly required to do so unless they are sold to non-accredited investors, private fund managers typically provide potential investors with certain disclosures about the fund similar to what would be required if the fund's securities were registered, such as how the fund operates, fees, potential conflicts of interest, and permissible investment strategies. — Broad discretion is generally retained by the manager with respect to investment strategies.

    — Investors typically receive performance information, risk analysis, and portfolio profiles.

    — Most private funds retain auditors to conduct independent audits using generally accepted accounting principles, and to provide some independent review of the fair value of fund assets. This is not explicitly required by US law.

Regulatory Proposals

    — The leading regulatory proposals in the US would require registration of virtually all fund managers. They would not regulate the funds themselves but fund managers would be subject to comprehensive reporting, recordkeeping and examination requirements.[3]— Managers also would be subject to other requirements in the existing regulatory regime for registered advisers, including the adoption of compliance policies and procedures and some limitations on advisory fees.

    — Under current proposals, only fund managers determined to be systemically significant because of the combination of their size, leverage, and interconnectedness with other critical market players would be subject to any capital, leverage, liquidity, or investment strategy limitations.

The US vs the EU Approach

    Leverage, Liquidity, and Capital. Unlike the Directive, the US proposals would not impose limits on the leverage that fund managers could employ, appropriate liquidity management policies and strategies, or impose minimum capital requirements on managers.

    Valuation of Assets. The US effectively requires that a fund manager's written compliance policies and procedures address valuation. But the law does not specify how or by whom assets should be valued. The Directive, on the other hand, would require independent valuations of assets managed by fund managers.

    Custody of Funds. The US does not currently require that all registered advisers use an independent custodian or that a custodian be a particular type of entity.

    — The US Securities and Exchange Commission has proposed rule changes that would impose additional obligations where the custodian is not independent of the adviser. In such cases, the adviser would need to obtain verification from an independent registered public accountant and a written report of an independent, registered public accountant on the custodian's internal controls. If the custodian is not related to the adviser, only verification by a public accountant would be required.

    — In stark contrast, the Directive requires that an EU credit institution be appointed custodian of assets under management.

    Marketing. The US securities laws do not limit non-public cross-border marketing of private funds as long as investor eligibility criteria are met.

    — With some exceptions for smaller funds with few US customers, the proposals would require non US fund managers to register in the US in order to market their funds to US customers. However, they would then be subject to essentially the same restrictions as registered US fund managers.

    — The Directive, on the other hand, would only permit marketing under a passport in the EU for the first three years by EU-regulated managers with respect to EU funds. Offshore funds, even those managed by EU-regulated managers would not be able to rely on the passport and after the first three years would have to satisfy the tax information sharing provisions to be marketed in the EU under the passport.

    — Non-EU—for example US—managers would be required to wait for three years and prove equivalence of regulatory schemes before being able to market their funds in the EU.

September 2009

1   Long Term Capital Management ("LTCM") is often cited as a contrary example. Nevertheless, the systemic risk in this case related not to the positions in LTCM alone but primarily to the high level of correlation between LTCM and other large financial institutions. Back

2   ECB, Occasional Paper Series, No 34 August 2005 "Hedge Funds and their Implications for Financial Stability". Back

3   In addition to the proposal submitted by the Obama Administration, which would require registration of private fund managers who have more than US$30 million in AUM, two other bills are pending in the US Congress that would require registration of managers. The "Hedge Fund Adviser Registration Act of 2009," introduced in January in the House of Representatives by Michael Capuano and Michael Castle, and the "Private Fund Transparency Act," introduced in the Senate in June by Senator Jack Reed both would require registration of private fund managers. A bill introduced in January by Senators Charles Grassley and Carl Levin would require registration of funds (rather than managers) with at least US$50 million in assets or AUM. There is considerably more support in the US, however, including from the SEC, for registration of managers rather than of the funds themselves. Back

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