Managed Funds Association September 2013
EU REGULATION 101 GUIDE TO EUROPEAN OVERSIGHT
OF THE HEDGE FUND INDUSTRY
INTRODUCTION
Hedge funds play a vital role in helping a wide range of
institutions – from pensions to endowments to non-profits
– meet their financial obligations.
In Europe, hedge funds oversee roughly $549 billion in
assets, according to a recent report by Preqin1.
In 2011 a new financial services regulatory structure took
effect, which included the creation of the three new
European Supervisory Authorities.
This guide provides a brief overview of the European
policymaking and new regulatory structure, and provides
information on several issues of specific concern to
hedges funds – and the institutions that invest in them.
1Source: Preqin, February 2013
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ABOUT THE EUROPEAN UNION
The European Union (EU) is an economic and
political union of 27 Member States. The EU was
established in its current form in 1993 by the
Maastricht Treaty. The Treaty of Lisbon, the latest
amendment to the constitutional basis of the EU,
came into force in 2009.
The EU operates through a system of
supranational independent institutions.
These include the European Commission,
the Council of the European Union, the European
Council, the Court of Justice of the European
Union, and the European Central Bank. The
European Parliament is elected every five years.
According to the EU, its policy making is focused
on ensuring the free movement of people, goods,
services and capital.
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IMPORTANT INSTITUTIONS OF THE EU
The European Commission is the executive body of the European Union. The body is
responsible for proposing legislation, implementing decisions, upholding the Union’s
treaties and the general day-to-day running of the Union.
The Council of the European Union (sometimes called the Council or the Council of
Ministers) is the legislative institution that represents the executives of member states
(the other legislative body being the European Parliament).
The European Parliament is the directly elected parliamentary institution of the EU.
Together with the Council of the European Union and the European Commission, it
exercises the legislative function of the EU.
The European Council is comprised the EU heads of state, the President of the
European Commission and the President of the European Council. The European Council
has no formal legislative power. However, under the Treaty of Lisbon, it defines “the
general political directions and priorities" of the Union.
The European Central Bank is the EU institution that administers the monetary policy of
the 17 EU Eurozone member states. The bank was established by the Treaty of
Amsterdam in 1998, and is headquartered in Frankfurt, Germany.
European
Commission
Council of the
European Union
European
Parliament
European
Council
European
Central Bank
4
EUROPEAN SYSTEM OF FINANCIAL SUPERVISORS
In 2009, in response to the global financial crisis, the European Commission proposed a new
framework for financial supervision: The European System of Financial Supervisors (ESFS).
The ESFS is an institutional architecture of the EU's framework of financial supervision. It is composed
of three authorities: the European Banking Authority, the European Insurance and Occupational
Pensions Authority and the European Securities and Markets Authority.
ESFS European System of Financial Supervisors
EBA European Banking
Authority
EIOPA European Insurance
and Occupational
Pensions Authority
ESMA European Securities
and Markets
Authority
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In January 2011, the new framework was implemented, with the EBA, EIOPA and ESMA taking on the
responsibilities of previously existing regulatory bodies.
EBA European Banking
Authority
Committee of
European Banking
Supervisors
EIOPA European Insurance
and Occupational
Pensions Authority
Committee of
European Insurance
and Occupational
Pensions
Supervisors
ESMA European Securities
and Markets
Authority
Committee of
European Securities
Regulators
NEW
OLD
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NEW REGULATORY FRAMEWORK
To complement this framework, there is also a European Systemic Risk Board (ESRB). The
ESRB is an independent body within the EU, responsible for the macro-prudential oversight
of the financial system within the Union. Board Members of the ESRB include members of
the European Central Bank, National Bank Governors and Chairs of European Supervisory
Authorities (ESAs).
ESRB European Systemic Risk Board
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EUROPEAN SYSTEMIC RISK BOARD
THE NEW EU REGULATORY FRAMEWORK (IMPLEMENTED JANUARY 2011)
EBA European Banking
Authority
EIOPA European Insurance
and Occupational
Pensions Authority
ESMA European Securities
and Markets
Authority
ESRB European Systemic
Risk Board
Headquartered in Frankfurt, EIOPA regulates certain activities of credit institutions, financial
conglomerates, investment firms, insurance and reinsurance companies, and payment
institutions. It is responsible for supporting the stability of the financial system, transparency of
markets and financial products, as well as the protection of insurance policy holders and pension
members and beneficiaries. EIOPA is part of the European System of Financial Supervisors
(ESFS).
Headquartered in Frankfurt, the ESRB is responsible for the macro-prudential oversight of the
financial system within the EU to help mitigate or prevent systemic risks to financial stability. It is
charged with contributing to the smooth functioning of the EU’s internal market and ensuring a
sustainable contribution of the financial sector to economic growth.
Headquartered in Paris, ESMA is responsible for safeguarding the stability of the European
Union’s financial system by ensuring the integrity, transparency, efficiency and orderly
functioning of securities markets, as well as enhancing investor protection. It coordinates the
work of securities regulators, and across financial sectors by working closely with the other
authorities, in particular the EBA and EIOPA. ESMA is part of the European System of Financial
Supervisors (ESFS).
Headquartered in London, the EBA regulates European banks. The EBA has the power to
overrule national regulators, prevent regulatory arbitrage and promote fair competition
throughout the EU Common Reporting (COREP) is the standardized reporting framework
covering: credit risk, market risk, operational risk, own fund and capital adequacy ratios. EBA is
part of the European System of Financial Supervisors (ESFS).
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EUROPEAN SECURITIES AND MARKETS AUTHORITY (ESMA)
ESMA is the coordinating body for EU Member State financial regulators.
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More About ESMA’s Role
Role and Responsibilities
ESMA is responsible for coordinating actions of securities supervisors or adopting emergency
measures when a crisis situation arises.
ESMA is responsible for helping establishment and implement a single set of financial rules
across Europe. They have two primary goals:
• Ensure consistent treatment of investors across the EU, providing adequate investor protection
through effective regulation and supervision.
• Promote fair and equal competition among financial service providers and ensure effective and
cost-efficient supervision of supervised companies.
According to ESMA, the organization “contributes to the financial stability of the European Union, in
the short, medium and long-term, through its contribution to the work of the European Systemic Risk
Board, which identifies potential risks to the financial system and provides advice to diminish possible
threats to the financial stability of the Union.”
While ESMA is independent, there is full accountability towards the European Parliament, Council of
the EU and European Commission.
Source: www.esma.europa.eu/page/esma-short 10
EU REGULATORY PROCESS
Financial regulation in the EU is governed by the Lamfalussy Framework which established
the legislative approach to securities law.
It was adopted by the EU in the final report of the Committee of Wise Men on the Regulation of
European Securities Markets (an expert committee chaired by Baron Alexandre Lamfalussy).
The Lamfalussy Framework proposed a four-level approach to European securities legislation:
It first applied to the securities sector and was later extended to banking, insurance and
pensions.
The framework has been brought into compliance with the Treaty of Lisbon, which entered into
force in 2009, and the ESA and ESRB Regulations, which entered into force in 2010 and 2011,
respectively.
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Baron Alexandre Lamfalussy
Level 1: Framework Legislation The Commission presents a legislative
proposal to the Parliament and Council
of the EU for recommendations.
Level 2: Implementing Measures ESMA provides advice to the
Commission on implementing
measures. The Commission can take
this advice or implement on its own.
Level 3: Supervisory Convergence Ensures consistent application across
the EU.
Level 4: Enforcement
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Level 1: Framework Legislation
Level 2: Implementing Measures
Level 3: Supervisory Convergence
Level 4: Enforcement
Lamfalussy Framework at Work
EU REGULATIONS OF INTEREST
TO HEDGE FUNDS
There are a number of regulations currently under consideration in the EU that are of specific
interest to hedge funds. These include:
1. Alternative Investment Fund Managers Directive (AIFMD)
2. European Market Infrastructure Regulation (EMIR)
3. Short Selling Regulation
4. Review of Markets in Financial Instruments Directive (MiFID II)
5. Market Abuse Directive (MAD)
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ALTERNATIVE INVESTMENT FUND
MANAGERS DIRECTIVE (AIFMD)
In April 2009, the European Commission proposed a Directive on Alternative Investment Fund
Managers (AIFMs) with the objective of creating a comprehensive regulatory framework for European
Alternative Investment Fund Managers.
The proposed Directive was developed to help create common regulatory standards for all AIFMs that
met specific criteria. The final agreement on the framework Directive (Level I) was achieved in
November 2010 and the text entered into force in July 2011.
The Commission asked the European Securities and Markets Authority (ESMA) to provide technical
advice on the implementing measures of the AIFMD (Level 2).
ESMA and the European Commission have continued to develop implementation measures
throughout 2013.
Member States were to have transposed the Directive and its implementing measures by July 2013,
however, at the time of publication less than half of the 28 EU Member States have done so.
ESMA continues to develop guidelines on the AIFMD in a number of areas.
The final text of the AIFMD (July 2011) is here. More information on AIFMD here.
Sources:
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:174:0001:0073:EN:PDF
http://ec.europa.eu/internal_market/investment/alternative_investments_en.htm 14
EUROPEAN MARKET INFRASTRUCTURE
REGULATION (EMIR)
In September 2010, the European Commission published a proposal for a Regulation on OTC
derivatives, central counterparties (CCPs) and trade repositories, now commonly referred to as the
European Markets Infrastructure Regulation or “EMIR.” EMIR entered into force on August 16, 2012.
ESMA and the European Commission continue to develop technical standards on implementation.
EMIR is currently in its Level 2 implementation phase, with recent consultations coming from ESMA
and the other ESAs.
Notably, EMIR calls for:
• All OTC derivative contracts considered ‘eligible’, entered into between any financial and certain
non-financial counterparties (subject to conditions), will be required to be cleared by a CCP;
• All OTC derivative contracts not considered ‘eligible’ shall be subject to risk mitigation
requirements, including the exchange of collateral or a proportionate holding of capital;
• Counterparties to an OTC derivatives trade (cleared or not) shall report details of that trade to a
trade repository;
• CCPs shall be subject to registration and prudential and conduct of business regulation; and
• Trade repositories shall be subject to conduct of business regulation.
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SHORT SELLING REGULATION
In November 2011, European negotiators reached an agreement on an EU Regulation on Short
Selling and certain aspects of credit default swaps. The regulation, which entered into force on
November 1, 2012, was designed to establish a common regulatory framework and ensure greater
coordination and consistency between Member States. Among other items, the new regulation:
• Requires public disclosure of short positions over a certain threshold
• Requires parties entering into a short sale to have borrowed the instruments, entered into an
agreement to borrow them or made other arrangements to ensure they can be borrowed in time to
cover the deal.
• Requires notification of significant positions in credit default swaps that relate to EU sovereign
debt issuers.
• Provides competent authorities with temporary power to require greater transparency or impose
certain restrictions on short selling and credit default swap transactions.
Both ESMA and the European Commission were to conduct a review of the Short Selling Regulation
by the end of June 2013. ESMA released its findings on June 3, 2013; ultimately, it did not recommend
significant changes to the regulation. As of publication, the European Commission has yet to release
its review of the Short Selling Regulation. More information on EU short selling regulation can be
found here.
Source: http://ec.europa.eu/internal_market/securities/short_selling_en.htm
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MARKETS IN FINANCIAL INSTRUMENTS DIRECTIVE
(MIFID) II
The Markets in Financial Instruments Directive (MiFID) came into force in November 2007. It replaced and expanded
the Investment Services Directive. Its objective was to increase the integration and efficiency of EU financial markets.
MiFID established a common regulatory framework for investment services in financial instruments across the EU and for
the operation of regulated markets by market operators.
The European Commission is currently reviewing the MiFID framework. In October 2011, the European Commission
adopted proposals for (i) a revised Directive and (ii) a new Regulation (MiFIR). Both the European Parliament and Council
of the EU have approved their respective reports on the MiFID proposal and are currently (September 2013) engaged in
trialogue with the European Commission.
Between them, these proposals:
• Extend the existing regulatory framework both in terms of instruments and firms covered, so that, for example, certain
commodity trading firms will fall within scope of the regime;
• Impose regulatory requirements on firms undertaking algorithmic trading (including HFT);
• Impose position limits on the trading of commodity derivatives;
• Impose restrictions on third country firms providing services in the EU;
• Introduce enhanced corporate governance requirements for investment firms; and
• Introduce enhanced pre- and post-trade transparency provisions in respect of both equities and non-equities.
More information about MiFID and MiFIR is available here.
Source: http://ec.europa.eu/internal_market/securities/isd/index_en.htm
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MARKET ABUSE DIRECTIVE (MAD)
In May 2001, the European Commission proposed a directive to address insider dealing and market
manipulation within the EU. The Market Abuse Directive (MAD) aimed to enhance the integrity of
European markets by implementing common standards throughout all Member States.
Currently (September 2013), negotiations among the European Parliament, Council of the EU, and the
European Commission are close to finishing.
More information on MAD available here.
Source: http://ec.europa.eu/internal_market/securities/abuse/index_en.htm
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REFERENCES
European Resources:
European Commission
http://ec.europa.eu/index_en.htm
European Parliament
http://www.europarl.europa.eu/news/en/headlines/
Council of the European Union
http://consilium.europa.eu/homepage?lang=en
European Securities and Market Authority (ESMA)
www.esma.europa.eu/
European Banking Authority (EBA)
http://www.eba.europa.eu/
European Insurance and Occupational Pensions
Authority (EIOPA)
https://eiopa.europa.eu/
European Systemic Risk Board
www.esrb.europa.eu
European Central Bank
http://www.ecb.int
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Information on the global hedge fund industry is available at the Managed Funds Association at
www.managedfunds.org and via Twitter: @MFAUpdates
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