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.
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.
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
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.
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.
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.
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
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
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
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
(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
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.
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.
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
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
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.
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
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
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
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
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
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.
| Registration for fund manager/adviser
|Registration for fund||No
|Liquidity management rules||No*
|Cross-border marketing restrictions||No***
| * 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.
US FUND 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
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
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.
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.
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
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
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-EUfor example USmanagers would be
required to wait for three years and prove equivalence of regulatory
schemes before being able to market their funds in the EU.
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
ECB, Occasional Paper Series, No 34 August 2005 "Hedge
Funds and their Implications for Financial Stability". Back
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