Sunday, May 23, 2010

The Impact of Tightening Financial Regulation

The last week has witnessed tighter financial regulations emerging out of the U.S. and European markets. While some of the reforms are expected to result in migration of investments into more liberal markets in Asia (including India), others represent introduction of stringent measures that are already in place in India.

Possible Regulatory Arbitrage

First, the European Union finance ministers have approved more stringent regulation of hedge funds. Objections have already been registered to this move, particularly by the U.K.:

The proposal, which would impose transparency standards on hedge-fund managers based outside of the EU, was endorsed by a majority of ministers over U.K. objections at a meeting in Brussels today. Osborne told reporters he was “very pleased” that his counterparts had listened to his concerns that the provisions could harm U.K. interests.

Britain is home to 80 percent of European hedge-fund and 60 percent of private-equity managers, according to a report last year from the Financial Services Authority. It’s also a hub for non-EU funds looking to market in Europe. The U.K. didn’t have enough support among ministers to stop the law from taking another step toward being implemented.

The proposals have been subject to critical review by the financial press. As the Economist notes:

On May 17th and 18th the two committees agreed to proposals that are intended to govern “alternative investment funds”, a long-winded name for hedge funds and private-equity funds, two sectors that in the eyes of many exemplify the ugly face of free-market capitalism. Confusingly the drafts contradict each other in some important respects; both differ, too, from a draft law proposed by the European Commission, Europe’s executive branch.

Other areas of concern include proposals to impose bank-like limits on the pay of fund managers—ostensibly to limit risk-taking even though the risks they take are anything but bank-like—as well as constraints on how much funds can borrow. Investors are also worried by measures to increase the liability that custodian banks have for the assets they look after. Pension funds and others fear they will be charged a higher premium by custodians as a result.

Not all these proposals will survive the reconciliation process. What seems likely to emerge is a messy compromise that will not drive the industry out of business or out of Europe, but will do little to improve financial stability either.

The Financial Times considers these measures a response to a non-existent problem:

German politicians have long complained about the destabilising effects of hedge fund and private equity "locusts" in financial markets. Now they and other European Union legislators are using the subprime mortgage and Greek debt crises to justify a crackdown.

This might be fair if hedge funds had caused either event, but they did not. Banks such as IKB, which went on a collateralised debt obligation bender with its "Rhineland" structured investment vehicle before collapsing, were more to blame. I have not, however, heard Germany call for European oversight of its industrial and regional banks.

The French and German governments have often wanted to subdue Anglo-Saxon finance and now have other EU members behind them, including Spain, holder of the current EU presidency. But the Alternative Investment Fund Managers Directive that was this week thrust on George Osborne, Britain's new chancellor of the exchequer, is protectionist, prescriptive and perverse.

As far as the Asian region is concerned, the key question is whether all this will result in a migration of hedge funds from Europe to the Asian markets, a phenomenon that the Economic Times examines. It remains to be seen whether hedge funds are likely to flood the Indian stock market in particular.

Currently, hedge funds may come in through the “front door” and invest directly by registering themselves with SEBI as foreign institutional investors (FIIs). Alternatively, they can invest in an indirect fashion through offshore derivative instruments (ODIs) (such as participatory notes) issued by other registered FIIs. Although the ODI route was restricted by SEBI in 2007, that decision was reversed in 2008, thereby permitting ODI investments by entities such as hedge funds, subject of course to relevant KYC (know-your-client) and disclosure norms (discussed here and here). Arguably, the persistence of the ODI route in the Indian markets provides a more liberal framework compared to the strengthening regimes in markets such as the European Union.

Tighter Controls Already in Existence in India

Second, there are two sets of changes introducing stringent measures that are already an integral part of financial market regulation in India.

In the U.S., the Securities and Exchange Commission (SEC) has proposed stock-by-stock circuit breaker rules “under which [the authorities] would pause trading in certain individual stocks if the price moves 10 percent or more in a five-minute period.” This is in response to the disruption caused to the markets on May 6 whereby “the market dropped significantly and after approximately 30 S&P 500 Index stocks fell at least 10 percent in a five-minute period.” As Sandeep Parekh points out, circuit breakers in individual stocks have been operational in India for over a decade.

Moving to Germany, it banned “naked short sales of euro-denominated government bonds, credit default swaps based on those bonds, and shares in Germany's 10 leading financial institutions.” This is similar to the ban on naked short sales imposed by the SEC in the U.S. in the wake of the financial crisis, which has thereafter been continued on a more enduring basis. Again, the Indian regulators appear to have acted with foresight in prohibiting naked short sales in the first place when short selling was introduced into the Indian markets in a structured fashion.

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